DP11352 The Tail that Wags the Economy: Beliefs and Persistent Stagnation

Author(s): Julian Kozlowski, Laura Veldkamp, Venky Venkateswaran
Publication Date: June 2016
Date Revised: October 2018
Keyword(s): belief-driven business cycles, propagation, Stagnation, tail risk
JEL(s): D84, E32
Programme Areas: Financial Economics, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11352

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.