When linear models are misleading

Jeremy Chiu and Sinem Hacioglu Hoke.

When shocks cause trouble

Small shocks can lead to big crises. At the heart of this issue is that economic dynamics might play out very differently against different backdrops: the same shock would have a very different effect if it hit the economy at the heights of the Great Recession than if it hit during more benign times. It might knock the economy into a more severe and persistent recession or financial stress if it hits already turbulent periods. It seems reasonable, therefore, that we would want to take into account the economic backdrop when we estimate our models.

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