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'Animal Spirits' and Business Cycles

Emotions and behavior can affect economic output as much as, if not more than, core economic factors.

Michael M. Pompian, 04/20/2017

This is the second in a series called Behavioral Finance and Macroeconomics. We will explore the effect behavior has on markets and the economy as a whole--and how advisors who understand this relationship can work more effectively with their clients. 

It is important for advisors to understand the impact human behavior has on the economy and how economists think about the subject. This can help you explain to your clients what happens to mass psychology during recessions and expansions--and when recessions (or worse) happen, what psychological factors bring the economy and the markets back on track. 

The following chart shows GDP growth in the United States from the 1940s to today. There have been 11 recessions during the period, as represented by the gray columns. 

What causes recessions? What brings the economy out of a recession? And what impact do consumer and investor behavior have on the business cycle? 

To answer these questions, it's important to understand a concept developed by John Meynard Keynes called "Animal Spirits."

In "The General Theory of Employment, Money, and Interest," Keynes describes economic behavior not just by core economic principles, but by emotional and behavioral factors as well:

"Our decision to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits — which is a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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