Uncertainty traps

Pablo D. Fajgelbaum, Edouard Schaal, Mathieu Taschereau-Dumouchel

Research output: Contribution to journalArticlepeer-review

25 Scopus citations

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 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.

Original languageEnglish (US)
Pages (from-to)1641-1692
Number of pages52
JournalQuarterly Journal of Economics
Volume132
Issue number4
DOIs
StatePublished - Nov 1 2017
Externally publishedYes

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics

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