Uncertainty Traps

92 Pages Posted: 19 Mar 2014 Last revised: 30 Jul 2021

See all articles by Pablo D. Fajgelbaum

Pablo D. Fajgelbaum

University of California, Los Angeles (UCLA)

Edouard Schaal

New York University (NYU), Department of Economics

Mathieu Taschereau-Dumouchel

Cornell University - Department of Economics

Date Written: March 2014

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. While 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.

Suggested Citation

Fajgelbaum, Pablo D. and Schaal, Edouard and Taschereau-Dumouchel, Mathieu, Uncertainty Traps (March 2014). NBER Working Paper No. w19973, Available at SSRN: https://ssrn.com/abstract=2411276

Pablo D. Fajgelbaum (Contact Author)

University of California, Los Angeles (UCLA) ( email )

405 Hilgard Avenue
Box 951361
Los Angeles, CA 90095
United States

Edouard Schaal

New York University (NYU), Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

Mathieu Taschereau-Dumouchel

Cornell University - Department of Economics ( email )

414 Uris Hall
Ithaca, NY 14853-7601
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
20
Abstract Views
585
PlumX Metrics