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Confidence Collapse in Macroeconomic Systems
Despite their inability to cope with the Global Financial Crisis and various subsequent calls to "Rebuild Macroeconomics", Dynamics Stochastic General equilibrium (DSGE) models are still at the forefront of monetary policy around the world. Like many standard economic models, DSGE models rely on the figment of representative agents, abolishing the possibility of genuine collective effects (such as crises like the 2008 GFC) induced by heterogeneities and interactions. By allowing feedback of past aggregate consumption on the sentiment of individual households, we pave the way for a class of more realistic models that allow for large output swings induced by relatively minor variations in economic conditions and amplified by interactions. Several important conceptual messages follow from our work, for example the de facto impossibility to price extreme risks and the importance of narratives, which may be an efficient depression-prevention policy tool whenever confidence collapse is looming.