Endogenous business cycles with financial frictions

This paper uncovers a series of belief shocks that drive the U.S. economy from both financial markets data and a financial accelerator model with self-fulfiling prophecies. Indeterminacy in the economy does not require externalities or increasing returns in production but it arises from an endogenous and countercyclical markup channel. The computed belief shocks are well identified and resemble the observable proxy in the real world. The model-driven solely by belief shocks performs well on replicating major U.S. business cycle facts. The belief-driven model contains a strong internal propagation mechanism and has more forecasting ability than a standard real business cycle model disturbed by technology shocks.