The Tail that Wags the Economy: Belief-Driven Business Cycles and Persistent Stagnation

Abstract

The "Great Recession" was a deep downturn with long-lasting effects on credit markets, labor markets and output. We explore a simple explanation: This recession has been more persistent than others because it was perceived as an extremely unlikely event before2007. Observing such an episode led all agents to re-assess macro risk, in particular, the probability of tail events. Since changes in beliefs endure long after the event itself has passed and through its effects on prices and choices, it produces long-lasting effects on investment, employment and output. To model this idea, we study a production economy with agents who use standard econometric tools to estimate the distribution of aggregate shocks. When they observe a new shock, they re-estimate the distribution from which it was drawn. Even transitory shocks have persistent effects because, once observed, they stay forever in the agents' data set. We feed a time-series of US macro data into our model and show that our belief revision mechanism can explain the 12% downward shift in US trend output.JEL Classifications: D84, E32

Financial Frictions and Fluctuations in Volatility

“…One reason for this tight connection is that agents know exactly when the volatility shifts. A more elaborate stochastic structure on information in which agents receive only noisy signals of the underlying aggregate shocks, such as in Kozlowski, Veldkamp, and Venkateswaran (2016), would allow the model to break this tight connection. Another reason is that we have abstracted from other mechanisms, such as adjustment costs in debt or in labor, search frictions, and so on, that stretch out the impact of shocks on aggregates.…”

Accounting for Macro-Finance Trends: Market Power, Intangibles, and Risk Premia

“…One interpretation is that this increase 24. Kozlowski, Veldkamp, and Venkateswaran (2018) offer a quantitative theory along these lines.…”

Endogenous Uncertainty and Credit Crunches

“…The model deviates from this standard setup in two respects: First, firms produce subject to a working capital constraint, where the tightness of the constraint depends on how "local" (island-specific) 8 Two other related strands of the literature study the propagation of exogenous uncertainty through real options as in Bloom (2009), Bloom et al (2014, and Bayer (2009, 2013), and through risk premia as in the time-varying (disaster) risk literature (e.g., Gabaix, 2012;Gourio, 2012). Related to the latter, Kozlowski, Veldkamp and Venkateswaran (2015) explore a model where agents learn about tail-risks and where belief revisions after short-lived financial shocks can have long-lasting effects. Similar, Nimark (2014) presents a mechanism that increases uncertainty after rare events, if news selectively focus on outliers.…”