Endogenous Uncertainty and Credit Crunches
34 Pages Posted: 1 Oct 2015 Last revised: 26 Dec 2017
Date Written: December 25, 2017
We develop a theory of endogenous uncertainty where the ability of investors to learn about firm-level fundamentals declines during financial crises. At the same time, higher uncertainty reinforces financial distress, causing a persistent cycle of uncertainty, pessimistic expectations, and financial constraints. Through this channel, a temporary shortage of funds can develop into a long-lasting funding problem for firms. Financial crises are characterized by increased credit misallocation, volatile asset prices, high risk premia, an increased cross-sectional dispersion of returns, and high levels of disagreement among forecasters. A numerical example suggests that the proposed channel may significantly delay recovery from financial shocks.
Keywords: Belief traps, credit crunches, dispersed information, endogenous uncertainty, internal persistence of financial shocks, resource misallocation
JEL Classification: D83, E32, E44, G01
Suggested Citation: Suggested Citation