Negative economic shocks can cause waves of investor pessimism about the resilience of banks, which, in turn, generate additional adverse macroeconomic effects. This is commonly cited as an explanation for the economic havoc wrought by the global financial crisis of 2007-08. We introduce the notion of pessimism in a real business cycle model, which is a standard framework for business cycle analysis. The possibility of waves of pessimism generates countercyclical demand from banks for liquid assets (e.g., bank reserves). With the model, we study the macroeconomic effects of the government supplying liquid assets and find that a policy of accommodating banks’ demand is effective in stabilising the economy. Finally, we support this finding with empirical evidence.
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