The Tail that Wags the Economy: Beliefs and Persistent Stagnation
61 Pages Posted: 7 Feb 2019 Last revised: 31 Mar 2020
Date Written: February, 2019
Abstract
The Great Recession was a deep downturn with long-lasting effects on credit, employment and output. While narratives about its causes abound, the persistence of GDP below pre-crisis trends remains puzzling. We propose a simple persistence mechanism that can be quantified and combined with existing models. Our key premise is that agents don't know the true distribution of shocks, but use data to estimate it non-parametrically. Then, transitory events, especially extreme ones, generate persistent changes in beliefs and macro outcomes. Embedding this mechanism in a neoclassical model, we find that it endogenously generates persistent drops in economic activity after tail events.
Keywords: Stagnation, tail risks, propagation, belief-driven business cycles
JEL Classification: D84, E32
Suggested Citation: Suggested Citation