On the Transmission of Small and Large Shocks

Abstract

We analyze how small and large demand and supply shocks are transmitted in the economy. We use a behavioural macroeconomic model that is characterized by the fact that individuals lack the cognitive ability to understand the underlying model and to know the distribution of the shocks that hit the economy. We find, first, that when shocks are small the trajectory taken after the shock by output gap and inflation is unpredictable. In this case the signal provided by the shock is overwhelmed by the noise produced by the initial disequilbria at the moment of the shock. Second, when the shock is large (more than 5 standard deviations like in the case of the covid-shock) the subsequent trajectories taken by output gap and inflation typically coalesce around a good and a bad trajectory. The way this result comes about is that different initial conditions force the monetary authorities into making different choices about the interest rate. Sometimes these choices are bad so that the economy is forced into a bad trajectory and sometimes they are good pushing the economy into a benign trajectory. We also find that when the shocks are large the initial conditions in particular expectations have strong power in predicting which trajectory will be chosen.