BELIEF-TWISTING SHOCKS AND THE MACROECONOMY

Abstract

I study the role of shocks to beliefs combined with Bayesian learning in a standard equilibrium business cycle framework. In particular, I examine how a prior belief arising from the Great Depression may have influenced the macroeconomy during the last 75 years. In the model, households hold twisted beliefs concerning the likelihood and persistence of recession and boom states that are affected by the Great Depression. These initial beliefs are substantially different from the true data generating process and are only gradually unwound during subsequent years. Even though the driving stochastic process for technology is unchanged over the entire period, the nature of macroeconomic performance is altered considerably for many decades before eventually converging to the rational expectations equilibrium. This provides some evidence of the lingering effects of beliefs-twisting events on the behavior of macroeconomic variables.