The Tail that Wags the Economy: Beliefs and Persistent Stagnation

Julian Kozlowski, Laura Veldkamp, Venky Venkateswaran

NBER Working Paper No. 21719
Issued in November 2015, Revised in January 2017
NBER Program(s):CF, EFG

The Great Recession was a deep downturn with long-lasting effects on credit markets, labor markets and output. While narratives about what caused the recession abound, the persistence of GDP below its pre-crisis trend is puzzling. We propose a simple persistence mechanism that can be easily quantified and combined with existing models, even complex ones. Our solution rests on the premise that no one knows the true distribution of shocks to the economy. If agents use observed macro data to estimate this distribution non-parametrically, then transitory events, especially extreme events, generate persistent changes in beliefs and thus in macro outcomes. We apply our tool to an existing model, designed to explain the onset of the great recession, and find that adding belief updating endogenously generates the persistence of the downward shift in US output, colloquially known as “secular stagnation.”

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Document Object Identifier (DOI): 10.3386/w21719

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