Economic Implications of Extreme and Rare Events

A central role for economic policy involves understanding and reducing the impact of unexpected,extreme events. In this paper, we develop a simple economic framework with latentregime switches. This framework explains why investors and policymakers can decide not tohedge against extreme events, even those that are exogenous, with well understood probabilitiesand consequences. We also examine endogenous probabilities, where the consequencesare less well understood. Our most striking finding is that the benefits of sustained optimalinvestment are bounded and small. Thus, investors may knowingly ignore or exacerbate thelikelihood of extreme events, especially if there are informational costs to learning the structureof the financial environment...