NATIONAL BUREAU OF ECONOMIC RESEARCH
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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 February 2019
NBER Program(s):Corporate Finance Program, Economic Fluctuations and Growth Program

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 quantfied 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.

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Document Object Identifier (DOI): 10.3386/w21719

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