Working Paper: NBER ID: w24984
Authors: Jess Benhabib; Xuewen Liu; Pengfei Wang
Abstract: Uncertainty in both financial markets and the real economy rises sharply during recessions. We develop a model of informational interdependence between financial markets and the real economy, linking uncertainty to information production and aggregate economic activities. We argue that there exists mutual learning between financial markets and the real economy. Their joint information productions determine both the allocative efficiency in the real sector and the market efficiency in the financial sector. The mutual learning creates a strategic complementarity between information production in the financial sector and that in the real sector. A self-fulfilling surge in financial uncertainty and real uncertainty can naturally arise when both sectors produce little information in anticipation of the other producing little information. At the same time, aggregate output falls as the real allocative efficiency deteriorates. In the extension to an OLG dynamic setting, our model characterizes self-fulfilling uncertainty traps with two steady-state equilibria and a two-stage economic crisis in transitional dynamics.
Keywords: financial markets; real economy; uncertainty
JEL Codes: E20; E44; G01; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Reduced information production (L15) | Increased uncertainty (D89) |
| Increased uncertainty (D89) | Lower economic output (F69) |
| Reduced information production (L15) | Lower economic output (F69) |
| Low aggregate output (E23) | Little incentive to acquire information (D83) |
| High aggregate output (E23) | Incentivized to acquire information (D83) |
| Adverse shocks (E32) | Impact on aggregate economic performance (F62) |
| Information contagion (D83) | Broader economic downturns (F44) |
| Strategic complementarity between information production in financial sector and real sector (D83) | Allocative efficiency in real sector and market efficiency in financial sector (D61) |