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Uncertainty Traps

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  • Pablo Fajgelbaum
  • Edouard Schaal
  • Mathieu Taschereau-Dumouchel

Abstract

We develop a theory of endogenous uncertainty and business cycles in which short-lived shocks can generate long-lasting recessions. In the model, higher uncertainty about fundamentals discourages investment. Since agents learn from the actions of others, information flows slowly in times of low activity and uncertainty remains high, further discouraging investment. The unique equilibrium of this economy displays uncertainty traps: self-reinforcing episodes of high uncertainty and low activity. While the economy recovers quickly after small shocks, large temporary shocks may have nearly permanent effects on the level of activity. The economy is subject to an information externality but uncertainty traps remain even in the efficient allocation. We extend our framework to include additional features of standard business cycle models and show, in that context, that uncertainty traps can substantially worsen recessions and increase their duration, even under optimal policy interventions.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19973.

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Date of creation: Mar 2014
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Handle: RePEc:nbr:nberwo:19973

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  1. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
  2. Steffen Elstner & Eric Sims & Ruediger Bachmann, 2010. "Uncertainty and Economic Activity: Evidence from Business Survey Data," 2010 Meeting Papers 614, Society for Economic Dynamics.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Uncertainty and the business cycle
    by Christian Zimmermann in NEP-DGE blog on 2014-03-30 16:38:48
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Cited by:
  1. Mayumi Ojima & Junnosuke Shino & Kozo Ueda, 2014. "Buyer-Size Discounts and Inflation Dynamics," UTokyo Price Project Working Paper Series 017, University of Tokyo, Graduate School of Economics.
  2. Scott R. Baker & Nicholas Bloom, 2013. "Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments," NBER Working Papers 19475, National Bureau of Economic Research, Inc.

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