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Federal Reserve Bank of St. Louis
Working Papers
The Tail that Wags the Economy: Beliefs and Persistent Stagnation
Julian Kozlowski
Laura Veldkamp
Venky Venkateswaran
Abstract

The Great Recession was a deep downturn with long-lasting effects on credit, employment and output. While narratives about its causes abound, the persistence of GDP below pre-crisis trends remains puzzling. We propose a simple persistence mechanism that can be quantified and combined with existing models. Our key premise is that agents don't know the true distribution of shocks, but use data to estimate it non-parametrically. Then, transitory events, especially extreme ones, generate persistent changes in beliefs and macro outcomes. Embedding this mechanism in a neoclassical model, we find that it endogenously generates persistent drops in economic activity after tail events.


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Julian Kozlowski & Laura Veldkamp & Venky Venkateswaran, The Tail that Wags the Economy: Beliefs and Persistent Stagnation, Federal Reserve Bank of St. Louis, Working Papers 2019-6, 03 Feb 2019.
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Keywords: Stagnation; tail risk; propagation; belief-driven business cycles
DOI: 10.20955/wp.2019.006
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