We study the macroeconomic implications of narratives, defined as beliefs about the economy that spread contagiously. In a typical business cycle model, narrative creates continuous and belief-driven change. A sufficiently contagious account can “go too far,” producing hysteresis in the unique equilibrium of the model. In practice, we use natural language processing techniques to measure firms’ narratives. Consistent with the theory, narratives spread contagiously and firms expand after adopting optimistic narratives, even though these narratives lack the power to predict firm future values. On average, the narrative explains 32% and 18% of the decline in output in the early 2000s and the Great Recession, respectively, and 19% of the variance in output.
That’s according to a new NBER working paper by Joel P. Flynn and Karthik Sastryx.
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