Financial Markets, the Real Economy, and Self-Fulfilling Uncertainties

65 Pages Posted: 17 Sep 2018

See all articles by Jess Benhabib

Jess Benhabib

New York University - Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER)

Xuewen Liu

University of Hong Kong (HKU) - Finance Area, Faculty of Business and Economics

Pengfei Wang

HKUST, Department of Economics; Hong Kong University of Science & Technology (HKUST) - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: September 2018

Abstract

Uncertainty in both financial markets and the real economy rises sharply during recessions. We develop a model of informational interdependence between financial markets and the real economy, linking uncertainty to information production and aggregate economic activities. We argue that there exists mutual learning between financial markets and the real economy. Their joint information productions determine both the allocative efficiency in the real sector and the market efficiency in the financial sector. The mutual learning creates a strategic complementarity between information production in the financial sector and that in the real sector. A self-fulfilling surge in financial uncertainty and real uncertainty can naturally arise when both sectors produce little information in anticipation of the other producing little information. At the same time, aggregate output falls as the real allocative efficiency deteriorates. In the extension to an OLG dynamic setting, our model characterizes self-fulfilling uncertainty traps with two steady-state equilibria and a two-stage economic crisis in transitional dynamics.

Suggested Citation

Benhabib, Jess and Liu, Xuewen and Wang, Pengfei, Financial Markets, the Real Economy, and Self-Fulfilling Uncertainties (September 2018). NBER Working Paper No. w24984, Available at SSRN: https://ssrn.com/abstract=3246781

Jess Benhabib (Contact Author)

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

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Xuewen Liu

University of Hong Kong (HKU) - Finance Area, Faculty of Business and Economics ( email )

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Pengfei Wang

HKUST, Department of Economics ( email )

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Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China

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