Financial Markets, the Real Economy, and Self-fulfilling Uncertainties

Jess Benhabib, Xuewen Liu and Pengfei Wang

No 24984, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Uncertainty in both financial markets and the real economy rises sharply during recessions. We develop a model of informational interdependence between financial markets and the real economy, linking uncertainty to information production and aggregate economic activities. We argue that there exists mutual learning between financial markets and the real economy. Their joint information productions determine both the allocative efficiency in the real sector and the market efficiency in the financial sector. The mutual learning creates a strategic complementarity between information production in the financial sector and that in the real sector. A self-fulfilling surge in financial uncertainty and real uncertainty can naturally arise when both sectors produce little information in anticipation of the other producing little information. At the same time, aggregate output falls as the real allocative efficiency deteriorates. In the extension to an OLG dynamic setting, our model characterizes self-fulfilling uncertainty traps with two steady-state equilibria and a two-stage economic crisis in transitional dynamics.

JEL-codes: E2 E44 G01 G20 (search for similar items in EconPapers)
Date: 2018-09
New Economics Papers: this item is included in nep-dge, nep-fdg, nep-mac and nep-mic
Note: CF EFG
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Published as JESS BENHABIB & XUEWEN LIU & PENGFEI WANG, 2019. "Financial Markets, the Real Economy, and Self‐Fulfilling Uncertainties," The Journal of Finance, vol 74(3), pages 1503-1557.

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Journal Article: Financial Markets, the Real Economy, and Self‐Fulfilling Uncertainties (2019)
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