The recent Great Recession is a stark reminder that financial markets and disturbances that affect them can have a big impact on the macroeconomy. But why did crisis occur in 2008 and why was it so severe? Did policy-makers, households or firms have a decent approximation of the “true” probability of the crisis prior to the 2007-08 financial collapse?

To answer these questions we build a simple theoretical model featuring financial markets and imperfect information: consumers, workers, and firms observe and learn continuously about the world they live in. We find that not only financial shock but also what people thought of it mattered for the economy. An overview of these results was presented in ASSA 2017 in Chicago.