NYU Mathieu Taschereau-Dumouchel

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 fundamen-tals 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 unique equilibrium of this 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 nearly permanent effects on the level of activity. The econ-omy is subject to an information externality but uncertainty traps remain even in the efficient allocation. We extend our framework to include additional features of standard business cycles models and show that uncertainty traps can substantially worsen recessions and increase their duration, even under optimal policy interventions