DP11352 | The Tail that Wags the Economy: Belief-Driven Business Cycles and Persistent Stagnation

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The Great Recession was a deep downturn with long-lasting effects on credit markets, labor markets and output. We explore a simple explanation: This recession has been more persistent than others because it was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to re-assess macro risk, in particular, the probability of tail events. Since changes in beliefs endure long after the event itself has passed and through its effects on prices and choices, it produces long-lasting effects on investment, employment and output. To model this idea, we study a production economy with agents who use standard econometric tools to estimate the distribution of aggregate shocks. When they observe a new shock, they re-estimate the distribution from which it was drawn. Even transitory shocks have persistent effects because, once observed, they stay forever in the agents' data set. We feed a time-series of US macro data into our model and show that our belief revision mechanism can explain the 12% downward shift in US trend output.