Uncertainty Traps
Pablo Fajgelbaum, Edouard Schaal & Mathieu Taschereau-Dumouchel
Issue Date March 2014
Revision Date May 2016
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.
We thank the editor Robert Barro and two anonymous referees for valuable suggestions. Liyan Shi and Chunzan Wu provided superb research assistance. We are grateful to Andrew Abel, Andrew Atkeson, Michelle Alexopoulos, Jess Benhabib, Harold Cole, Michael Evers, João Gomes, William Hawkins, Patrick Kehoe, Lars-Alexander Kuehn, Ali Shourideh, Laura Veldkamp, Pierre-Olivier Weill and seminar participants for useful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Pablo D. Fajgelbaum & Edouard Schaal & Mathieu Taschereau-Dumouchel, 2017. "Uncertainty Traps*," The Quarterly Journal of Economics, vol 132(4), pages 1641-1692. citation courtesy of