The Effect of Confidence on Asset Pricing and the Macroeconomy

The introduction of consumer and producer confidence in the Consumption-based Capital Asset Pricing Model (CCAPM) can materially alter the equilibrium levels of real output, prices of goods/services, and security returns within a rational expectations equilibrium framework. Our main result is that the one-factor CCAPM becomes a more complex, multiple factor model when confidence is included. In addition to confidence, the key factors affecting security returns are monetary and fiscal policies, as well as the long run equilibrium growth rate of the economy. Numerical and empirical exercises exploring the dynamics of the model suggest that the effectiveness of monetary and fiscal policies, as well as the required return on risky securities, be predicated on the level of confidence. The model attempts to bridge the gap between traditional rational asset pricing models and more recent attempts to develop “behavioral” financial models. Several empirically testable hypotheses of the model are also proposed. This paper reviews the role that consumer and producer confidence can play in the macroeconomy and financial markets. This topic is particularly salient given the recent discussion by economists, investors, and journalists about the Federal Reserve Chairman’s comments concerning the possible presence of “irrational exuberance” in the financial markets. Near-record levels of consumer confidence and the debate on whether a “New Economy” driven by technological innovation exists in the U.S. have also fueled discussion of the role of confidence in the economy and security markets. To address the role of confidence in these areas, we develop a rational expectations equilibrium model that explicitly includes the effects of consumer and producer confidence. This macroeconomic model is then linked to a well-known model of financial asset pricing (the Consumption-based Capital Asset Pricing Model, or CCAPM, of Breeden, 1979) in an attempt to provide a more detailed, multiple factor, description of the relation between risk and return in the financial markets. Recent empirical results of the CCAPM in Lettau and Ludvigson (2000) suggest the explanatory power of this model can be improved greatly when it is cast in terms of conditional expectations of security returns. Our paper explores how the level of confidence among important economic agents such as producers and consumers can affect the rational expectations equilibria in both the goods and security markets. In the context of Lettau and Ludvigson (2000), our paper can provide a detailed theoretical rationale for the conditioning process Lettau and Ludvigson use to improve the CCAPM’s explanatory power. Namely, their conditioning variable can be viewed as a proxy for consumer and producer confidence in our framework. The role of consumer/producer confidence (sometimes referred to as sentiment) has been studied in the economics literature on an intermittent basis. Pioneering work in the construction of consumer sentiment indexes at the University of Michigan by Katona during 1945-1955 spurred initial interest in the economic role of confidence. Early statistical work by Katona and his colleagues showed that the indexes were able to improve the explanatory power of models designed to predict changes in aggregate economic factors such as consumer durable goods purchases. However, empirical research in the late 1950s and early 1960s cast doubt on the earlier results of Katona. Several papers during this time period indicated consumer sentiment added little explanatory power beyond that which was available from “more objective” data such as past durable goods purchases and current stock price levels. With the results of this later research, most economists shifted their research focus to other topics. It was not until the early 1990s that significant interest was renewed in the role of