Working Paper: NBER ID: w19973
Authors: Pablo Fajgelbaum; Edouard Schaal; Mathieu Taschereau-Dumouchel
Abstract: We develop a theory of endogenous uncertainty and business cycles in which short-lived shocks can generate long-lasting recessions. In the model, higher uncertainty about fundamentals discourages investment. Since agents learn from the actions of others, information flows slowly in times of low activity and uncertainty remains high, further discouraging investment. The economy displays uncertainty traps: self-reinforcing episodes of high uncertainty and low activity. While the economy recovers quickly after small shocks, large temporary shocks may have long-lasting effects on the level of activity. The economy is subject to an information externality but uncertainty traps may remain in the efficient allocation. Embedding the mechanism in a standard business cycle framework, we find that endogenous uncertainty increases the persistence of large recessions and improves the performance of the model in accounting for the Great Recession.
Keywords: endogenous uncertainty; business cycles; investment; uncertainty traps; Great Recession
JEL Codes: E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Large shocks (E32) | Long-lasting recessions (E65) |
| Higher uncertainty about economic fundamentals (D89) | Investment (G31) |
| Uncertainty traps (D89) | Persistent recessions (E32) |