Working Paper: NBER ID: w17900
Authors: Cosmin Ilut; Martin Schneider
Abstract: This paper considers business cycle models with agents who dislike both risk and ambiguity (Knightian uncertainty). Ambiguity aversion is described by recursive multiple priors preferences that capture agents' lack of confidence in probability assessments. While modeling changes in risk typically requires higher-order approximations, changes in ambiguity in our models work like changes in conditional means. Our models thus allow for uncertainty shocks but can still be solved and estimated using first-order approximations. In our estimated medium-scale DSGE model, a loss of confidence about productivity works like 'unrealized' bad news. Time-varying confidence emerges as a major source of business cycle fluctuations.
Keywords: business cycles; ambiguity aversion; confidence shocks
JEL Codes: E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Loss of confidence about productivity (D24) | Recession (E32) |
| Loss of confidence about productivity (D24) | Decline in consumption (D12) |
| Loss of confidence about productivity (D24) | Decline in investment (E22) |
| Loss of confidence about productivity (D24) | Decline in hours worked (J22) |
| Confidence shocks (E32) | Positive comovement between consumption, investment, and hours worked (E20) |
| Changes in confidence (E32) | Booms characterized by high output and employment levels (E32) |
| Confidence shocks (E32) | Economic fluctuations (E32) |
| Confidence shocks (E32) | Significant effects on steady state of endogenous variables (C32) |
| Confidence shocks (E32) | Welfare costs associated with ambiguity (D69) |
| Confidence shocks (E32) | Accounts for a sizable fraction of output variance (D29) |