Confidence, Crashes and Animal Spirits

Abstract

This paper presents a model of the macroeconomy that reformulates what I take to be two important ideas from Keynes General Theory. The first is that there may be a continuum of steady state unemployment rates. The second is that beliefs select an equilibrium. I argue that search and matching costs in the labor market lead to the existence of a continuum of equilibria and I resolve the resulting indeterminacy by assuming that the beliefs of stock market participants are self-fulfilling. The paper reconciles Keynesian economics with general equilibrium theory without invoking the assumption of frictions that prevent wages and prices from reaching their equilibrium levels.