Financial Markets, the Real Economy, and Self-fulfilling Uncertainties
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.
We are grateful to the editor and two referees for their detailed comments and suggestions that have significantly improved the paper. We thank Russell Cooper, Feng Dong, Gaetano Gaballo, Shiyang Huang, Alexander Kohlhas, Wei Xiong, Liyan Yang, Kathy Yuan, Zhen Zhou, and seminar participants at the FIRS conference 2018, Wharton Conference on Liquidity and Financial Fragility 2017, Barcelona GSE Summer Forum 2017 - Information frictions, HKUST Macro Workshop 2017, Tsinghua Finance Workshop 2017, AFR Summer Institute of Economics and Finance 2017, Ningbo International Finance Conference 2016, CUHK-Shenzhen, Tsinghua PBC, CKGSB, Shanghai Jiao Tong University (SAIF), and HKUST for helpful comments. Liu and Wang acknowledge the financial support from the Hong Kong Research Grants Council (GRF #16504815). The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
JESS BENHABIB & XUEWEN LIU & PENGFEI WANG, 2019. "Financial Markets, the Real Economy, and Self‐Fulfilling Uncertainties," The Journal of Finance, vol 74(3), pages 1503-1557. citation courtesy of