Julian Kozlowski, New York University, and Laura Veldkamp and Venky Venkateswaran, New York University and NBER

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

The "Great Recession" was a deep downturn with long-lasting effects on credit markets, labor markets and output. Kozlowski, Veldkamp, and Venkateswaran 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, the researchers 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. The authors feed a time-series of U.S. macro data into their model and show that their belief revision mechanism can explain the 12% downward shift in U.S. trend output.