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‘ANIMAL SPIRITS’ GENERATE STOCK MARKET FLUCTUATIONS: New analysis and evidence for the US economy

  • Published Date: September 2017

Changes in investors’ expectations that aren’t driven by changes in the economic fundamentals explain 25-30% of the volatility of US stock prices, according to research by Professors Luca Gambetti, Mario Forni, Marco Lippi and Luca Sala, published in the September 2017 issue of the Economic Journal.

Their study of what pioneering economists Arthur Pigou and John Maynard Keynes called ‘animal spirits’ finds that the late 1990s dot-com bubble in the United States was clearly a situation in which changes in expectations unrelated to changes in the fundamentals caused the boom and bust in the stock market.

The researchers note that there has recently been renewed interest in the idea that fluctuations in stock prices could be driven by changes in expectations about future economic conditions. They clarify what they mean by animal spirits as follows.

Suppose that a discovery of a new technology is announced: a new and cheap material has been developed at the research laboratory of company X. There are rumours that this new material could be used to produce cheaper and more efficient microprocessors. Now the industrialisation phase of the new microprocessor is happening.

Suppose that you are an investor deciding whether to invest in the development of the microprocessor by buying stocks of company X. After the announcement has been made, there is still uncertainty about the outcome of the industrialisation phase. It could be that it will turn out positive, granting profits to the investors.

Alternatively, it could be that the development phase fails: it will turn out to be impossible to use the new material to develop the new microprocessor. As a result, expectations of higher future profits will be reduced and stock prices will go down.

The new study analyses this situation (as have previous authors) as investors receiving signals about dividends. The signals are the sum of two unobservable components: one a component relating to improvements in fundamentals; the other a component that shifts expectations of positive future dividends, but eventually no improvement happens.

Given the signal, the investor has to decide how much to invest in the firm. Only after some time will she realise whether or not the investment is profitable.

Suppose that after some time it is possible to see the final effect of the industrialisation phase. If it has been successful, the economy gradually reaches a new level of activity and expectations of future dividends are fulfilled. If it has been unsuccessful, stock markets return to the initial state. Movements in stock prices could be generated by shifts in expectations that are unrelated to economic fundamentals.

The authors of the new study believe that assuming that individuals base their decisions on noisy information seems quite plausible, in particular for events – such as improvements in technology – whose effects propagate slowly and therefore are not immediately revealed by observable economic variables.

People are uncertain about the future effects of news becoming available. Assuming that they are not aware of the exact nature of such news and use the information at hand optimally, is a simple and convenient way to analyse this kind of ‘conditional’ uncertainty.

In the empirical work in this study, the researchers measure the response of the US economy to a shock that increases fundamentals (what they call a ‘dividend shock) and a shock that does not affect the fundamentals (what they call a ‘noise shock’). The latter is an animal spirits shock: an event that changes public’s expectations, but does not change the economic fundamentals.

The econometric methodology is complex, but the key point to highlight is that the researchers’ strategy uses the idea that sometime in the future it is possible to see the final effect of the industrialisation phase.

Figure 1 shows the estimated responses of the US economy. The left column displays the response of dividends and stock prices after a shock to fundamentals. The right column displays the responses after a noise shock.

Both shocks raise stock prices. The dividend shock (left) has a long-run effect on dividends and stock prices: fundamentals have increased and stocks are worth more. The noise shock only has a temporary effect: once investors realise that the shock was noise, stock prices go down to the pre-shock level. The fraction of the volatility of stock prices generated by noise shocks is around 25-30%.

Analysing the timing of noise shocks in the US economy, the researchers notice that the dot-com bubble was generated by animal spirits – changes in expectations not driven by changes in the fundamentals.


Notes for editors: ‘Noise Bubbles’ by Luca Gambetti, Mario Forni, Marco Lippi and Luca Sala is published in the September 2017 issue of the Economic Journal.

Luca Gambetti is at Universitat Autonoma de Barcelona. Mario Forni is at Università di Modena e Reggio Emilia. Marco Lippi is at Università di Roma, La Sapienza. Luca Sala is at Università Bocconi in Milan.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email:; Twitter: @econromesh); Luca Gambetti via email:; Mario Forni via email:; Marco Lippi via email:; or Luca Sala via email: