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Uncertainty Traps

Listed author(s):
  • Pablo D. Fajgelbaum
  • Edouard Schaal
  • Mathieu Taschereau-Dumouchel
Registered author(s):

    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 economy displays uncertainty traps: self-reinforcing episodes of high uncertainty and low activity. Although the economy recovers quickly after small shocks, large temporary shocks may have long-lasting effects on the level of activity. The economy is subject to an information externality but uncertainty traps may remain in the efficient allocation. Embedding the mechanism in a standard business cycle framework, we find that endogenous uncertainty increases the persistence of large recessions and improves the performance of the model in accounting for the Great Recession.

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    File URL: http://hdl.handle.net/10.1093/qje/qjx021
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    Article provided by Oxford University Press in its journal The Quarterly Journal of Economics.

    Volume (Year): 132 (2017)
    Issue (Month): 4 ()
    Pages: 1641-1692

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    Handle: RePEc:oup:qjecon:v:132:y:2017:i:4:p:1641-1692.
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    1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    2. Foster, Andrew D & Rosenzweig, Mark R, 1995. "Learning by Doing and Learning from Others: Human Capital and Technical Change in Agriculture," Journal of Political Economy, University of Chicago Press, vol. 103(6), pages 1176-1209, December.
    3. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
    4. Abhijit V. Banerjee, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, Oxford University Press, vol. 107(3), pages 797-817.
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