Expectations Driven Nonlinear Business Cycles

There are two traditional conflicting views about the workings of a market economy. The socalled “Classical” school stresses the virtues of free markets and their intrinsic internal stability. According to that school, persistent, nonexplosive fluctuations should be essentially due to repeated external macroeconomic shocks to the “fundamental” characteristics of the system (technology, tastes, resources). Models of the “Classical” vintage typically assume that expectations are self-fulfilling, i.e. every individual’s assessment of the future (a probability distribution) is correct at any moment given his information. According to that view, expectations cannot be an independent source of economic fluctuations. There is another view, often associated to so-called “Keynesian” thinking, that starts with the observation that individual prophecies about aggregate outcomes often tend to be self-fulfilling if shared by sufficiently many people, and that suggests this phenomenon as a potential source of significant internal instability of socioeconomic systems in the absence of any outside regulation. According to that view, aggregate changes of expectations are likely to occur rather frequently in an unpredictable way and are potentially major sources of endogenous business fluctuations (market psychology, animal spirits).