Indeterminacy and saddle path stability in a neoclassical model of, banking sentiment dynamics

This paper analyses the role of banking sentiment—interpreted as “animal spirits”—in credit creation and the dynamics of physical capital. We develop a neoclassical dynamic model to examine how waves of optimism and pessimism in banks’ behaviour propagate into the real economy through credit creation. The model follows the Weidlich–Haag–Lux framework to formalise sentiment dynamics, in which banks’ average sentiment depends on herding behaviour among banks and deviations of physical capital from its steady-state level. We study the existence and stability properties of equilibria both analytically and numerically. The analysis shows that multiple equilibria arise when the contagion effect—measured by the strength of herding in banking sentiment—exceeds a critical threshold. In the multiple-equilibria regime, the economy exhibits saddle-path stability at both neutral and non-neutral equilibria under high contagion, while moderate contagion leads to indeterminacy at non-neutral sentiment equilibria. By contrast, when contagion is below the critical threshold, the economy converges to a unique equilibrium that displays indeterminacy. The model does not generate instability under any parameter configuration. Finally, the analysis shows that monetary policy is most effective in the optimistic equilibrium and least effective in the pessimistic equilibrium.