The Tail that Wags the Economy: Belief-Driven Business Cycles and Persistent Stagnation∗

In the wake of the “great recession,”many economists explored new sources of business cycle fluctuations, such as news, sentiment or uncertainty shocks. But these theories have diffi culty explaining why post-recession output would remain below trend long after many commonly used measures of uncertainty recovered to their pre-crisis levels. We propose a business cycle model where new information has persistent effects on real output. In our model, firms do not know the true distribution of economic shocks. Each period, they observe a new shock realization and re-estimate its distribution, just as an econometrician would. Tails of the distribution are diffi cult to estimate. So estimated tails risk can fluctuate greatly as new data is observed. Shocks have persistent effects because they permanently change beliefs about future realizations. Since debt payoffs are affected disproportionately by tail risk, changes to beliefs lead to large changes in the cost of issuing debt and therefore, incentives to invest. Thus, the combination of belief revisions and debt financing can amplify shocks and generate large, persistent fluctuations in investment and output. JEL Classifications: