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We provide a new theory of demand-driven business cycles based on learning from prices in an otherwise frictionless neoclassical model. In our model, house price increases caused by aggregate disturbances may be misinterpreted as a signal of higher local consumption prospects, leading households to expand their demand for current consumption and housing. Higher demand reinforces the initial house price increase in an amplication loop that drives comovement in output, labor, residential investment, and house prices even in response to aggregate supply shocks. The qualitative implications of the model are consistent with observed business cycles, and it can explain apparently autonomous changes in sentiment without resorting to non-fundamental shocks.
