What role did ‘animal spirits’ play in forming UK business cycles during the early stages of the COVID-19 pandemic?
By Yating Zhang.
Introduction
In conventional economic analysis, economic agents are widely considered to be rational utility maximisers (Akerlof and Shiller, 2009). The practicality of this assumption has stimulated economists to develop new theories and concepts to accommodate for variants of this convention. In this article, I intend to explore the relationship between ‘Animal spirits’, one such concept, and UK business cycles in the early stages of the current COVID-19 pandemic.
‘Animal spirits’ captures how the emotional mindsets: optimism and pessimism of economic decision-makers, influence output and investment by its self-fulfilling properties (Grauwe, 2010). Animal spirits are commonly observed in our daily lives, they play an inescapable role when making consumption decisions and investment decisions.
Business cycles, or economic cycles, are a cycle of fluctuations found in the aggregate economic activity of nations, which consists of recurrent but non-periodic expansions and recessions (Burns and Mitchell, 1946).
Several economists have highlighted, that business cycles do not necessarily represent optimal responses by rational agents. Economic activity can fluctuate from day to day independently of economic fundamentals (Farmer and Guo, 1994). The irrationality of agents, however, does not imply that individuals are not equipped with adequate ability to make good decisions. Animal spirits are not simply random mood swings or plain ignorance of human decision-makers. The complexity and the uncertainty of future decisions inevitably interfere with the decision-making process of economic agents (Franke, 2012; Grauwe, 2010).
Investigating the nature and fluctuations of animal spirits enables consumers and investors to understand the overall confidence of the population further and make optimal decisions accordingly with their predictions of future economic cycles.
Considering the current COVID-19 pandemic, the biggest economic shock in recent economic history, waves of optimism and pessimism of consumers’ and investors’ views on the British economy are very likely to be more dominant, compared with pre-pandemic levels. Panic buying of perishable goods and household essentials is a perfect illustration of this circumstance (Chua, Yuen, Wang and Wong, 2021). This phenomenon can be closely correlated with the unprecedented downward pressure the pandemic has imposed on the British economy. Investigating the link between the highly sensitive animal spirits during the pandemic and business cycles, is crucial to help the UK economy recover.
Focusing on the early stages of the pandemic, recent economic research has suggested that the spread of the virus depressed global demand through severe supply disruption and demand shocks (Fornaro and Wolf, 2020). A supply shock is anything that lowers the economy’s capacity of the production of goods and services, at given prices. This manifests itself during the pandemic in the form of social distancing measures, especially the shutdown of entire sectors which involve interpersonal contact, for instance, restaurants and salons (Brinca, Duarte and Faria-e-Castro, 2020). A demand shock weakens a consumer’s ability or willingness to purchase goods and services, at given prices. Due to lockdown measures, consumers not only decreased their uses of services and purchases of goods in the shut-down sectors, but jobless workers also reduced their consumption of all goods and services (Brinca, Duarte and Faria-e-Castro, 2020 ). This contributed to a severe demand shock, as 40% of the global workforce was estimated to be employed in sectors that face a high risk of worker displacement (Furceri et al, 2021). Hence, economies were hence , vulnerable to stagnation traps, driven by pessimistic animal spirits (Fornaro and Wolf, 2020).
To investigate the impacts of animal spirits on the UK’s business cycles during the pandemic, specifically due to a negative supply and demand shock in most sectors, I will apply a simplified version of a behavioural macroeconomic model developed in (Grauwe, 2011).
The Model
Due to the systematic incorporation of rational expectations in macroeconomic models, the concept of ‘animal spirits’ was excluded in mainstream macroeconomic theory (Grauwe, 2010). In the extensively employed Dynamic Stochastic General Equilibrium (DSGE) models, for instance, analyses on historical time-series data are set up based on exogenously generated fluctuations in investment and output. Over time, several economic papers: Azariadis (1981) and Farmer and Guo (1994) have strived to introduce animal spirits in dynamic general equilibrium models by assuming rational expectations together with aggregate fluctuations driven by animal spirits. These models mostly produce multiple equilibria.
It is worth noting that, the notions of ‘animal spirits’ and rational expectations tend to interfere with each other. Taking this into consideration, this paper will employ a simplified version of the model developed in Grauwe, 2010. This model considers economic agents’ cognitive limitations, making it a more practical model to comprehensively assess the role of animal spirits on affecting the UK business cycles during the early stages of the COVID-19 pandemic.
Assumptions:
This model illustrates an alternative approach to modelling animal spirits. In this framework, the main assumption is that individuals are constrained by cognitive limitations (Thaler, 1994) along with heterogeneity in the use of information (Hayek, 1945). As a result, economic agents use simple but generally biased rules, heuristics, to make decisions. The application of heuristics, however, is not a sign of irrationality in the neoclassical economics sense, but rather due to the complexity of the real economy.
A behavioural macroeconomic model
The model presents a standard aggregate-demand-supply model augmented with a Taylor rule. The novel feature of this model is that the concept of rationality is a bounded one, in which agents are aware of their cognitive limitations and biased beliefs but follow an adaptive learning mechanism, where they are willing to learn from mistakes their biases produce. Since agents use distinct heuristics , one obtains heterogeneity, which in turn creates an endogenous business cycle.
This article was written by Yating Zhang, a 2021–22 economic research analyst within the Economic Research Division, and was reviewed by Joe Marshall, the 2021–22 Head of Economic Research.
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