Endogenous Uncertainty and Credit Crunches

Abstract We develop a theory of endogenous uncertainty in which the ability of investors to learn about firm-level fundamentals is impaired during financial crises. At the same time, higher uncertainty reinforces financial distress. Through this two-way feedback loop, a temporary financial shock can cause a persistent reduction in risky lending, output, and employment that coincides with increased uncertainty, default rates, credit spreads, and disagreement among forecasters. We embed our mechanism into standard real business cycle and New-Keynesian models and show how it generates endogenous and internally persistent processes for the efficiency and labour wedges.