The Tail that Wags the Economy: Beliefs and Persistent Stagnation

63 Pages Posted: 27 Jun 2016 Last revised: 29 Oct 2018

See all articles by Julian Kozlowski

Julian Kozlowski

New York University (NYU)

Laura Veldkamp

Columbia University - Columbia Business School; National Bureau of Economic Research (NBER)

Venky Venkateswaran

New York University (NYU) - Leonard N. Stern School of Business; Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Multiple version iconThere are 3 versions of this paper

Date Written: June 2016

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: belief-driven business cycles, propagation, Stagnation, tail risk

JEL Classification: D84, E32

Suggested Citation

Kozlowski, Julian and Veldkamp, Laura and Venkateswaran, Venky, The Tail that Wags the Economy: Beliefs and Persistent Stagnation (June 2016). CEPR Discussion Paper No. DP11352, Available at SSRN: https://ssrn.com/abstract=2801033

Julian Kozlowski (Contact Author)

New York University (NYU) ( email )

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Laura Veldkamp

Columbia University - Columbia Business School ( email )

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National Bureau of Economic Research (NBER)

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Venky Venkateswaran

New York University (NYU) - Leonard N. Stern School of Business ( email )

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