Title: On rational fat tails
Authors: Chetan Dave - University of Alberta (Canada) [presenting]
Marco Maria Sorge - University of Salerno (Italy)
Abstract: The purpose is examine the role of sunspot shocks in generating fat-tailed behavior of endogenous variables in equilibrium business cycle models without departing from the Gaussian rational expectations (RE) benchmark. We formally establish that any RE model exhibiting indeterminacy admits a linear recursive equilibrium representation as a function of regularly varying multiplicative noise (LRMN). This, in turn, allows small shocks to fuel large deviations, thereby imparting non-Gaussian features to equilibrium patterns in standard Gaussian environments. Numerical simulations and an estimation exercise highlight the ability of LRMN representations to replicate statistical regularities with respect to fat-tailed distributions and high-probability extreme outcomes.