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Identification of Animal Spirits in a Bounded Rationality Model: An Application to the Euro Area

Jang, Tae-Seok and Sacht, Stephen (2012): Identification of Animal Spirits in a Bounded Rationality Model: An Application to the Euro Area.

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Abstract

In this paper, we empirically examine a heterogenous bounded rationality version of a hybrid New-Keynesian model. The model is estimated via the simulated method of moments using Euro Area data from 1975Q1 to 2009Q4. It is generally assumed that agents' beliefs display waves of optimism and pessimism - so called animal spirits - on future movements in the output and inflation gap. Our main empirical findings show that a bounded rationality model with cognitive limitation provides fits for auto- and cross-covariances of the data which are slightly better than or equal to a model where rational expectations are assumed. This implies that the bounded rationality model provides some structural insights on the expectation formation process at the macro-level for the Euro Area. First, over the whole time interval the agents had expected moderate deviations of the future output gap from its steady state value with low uncertainty. Second, we find strong evidence for an autoregressive expectation formation process regarding the inflation gap. Both observations explain a high degree of persistence in the output gap and the inflation gap.

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