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Title: The Tail that Wags the Economy: Beliefs and Persistent Stagnation

Author(s): Julian Kozlowski, Laura Veldkamp and Venky Venkateswaran

Publication Date: June 2016

Keyword(s): belief-driven business cycles, propagation, Stagnation and tail risk

Programme Area(s): Financial Economics and Macroeconomics and Growth

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.

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Bibliographic Reference

Kozlowski, J, Veldkamp, L and Venkateswaran, V. 2016. 'The Tail that Wags the Economy: Beliefs and Persistent Stagnation'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=11352