Published online by Cambridge University Press: 19 February 2018
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.
I especially thank James Bullard for support and very valuable discussions and suggestions. I also thank Klaus Adam, Costas Azariadis, James Morley, Albert Marcet, and Gabriela Nodari for their comments and suggestions and to participants at AEA Meeting, Econometric Society World Congress in Shanghai, International Workshop on Financial Markets and Nonlinear Dynamics, and many other conferences and seminars for comments. All errors are my own.