Working Paper: NBER ID: w22958
Authors: Cosmin L. Ilut; Hikaru Saijo
Abstract: We build a tractable heterogeneous-firm business cycle model where firms face Knightian uncertainty about their profitability and learn it through production. The cross-sectional mean of firm-level uncertainty is high in recessions because firms invest and hire less. The higher uncertainty reduces agents' confidence and further discourages economic activity. We characterize this feedback mechanism in linear, workhorse macroeconomic models and find that it endogenously generates empirically desirable cross-equation restrictions such as: amplified and hump-shaped dynamics, co-movement driven by demand shocks and countercyclical correlated wedges in the equilibrium conditions for labor, risk-free and risky assets. In a rich model estimated on US macroeconomic and financial data, the information friction changes inference and significantly reduces the empirical need for standard real and nominal rigidities. Furthermore, endogenous idiosyncratic uncertainty propagates shocks to financial conditions, disciplined by observed spreads, as key drivers of fluctuations, and magnifies the aggregate activity's response to monetary and fiscal policies.
Keywords: business cycles; uncertainty; learning; confidence
JEL Codes: C11; D81; E32; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased uncertainty (D89) | Reduced production (E23) |
| Increased uncertainty (D89) | Reduced hiring (J63) |
| Reduced production (E23) | Amplified economic downturns (E32) |
| Lower confidence in profitability (D89) | Higher estimation uncertainty (C13) |
| Higher estimation uncertainty (C13) | Reduced optimal size of productive inputs (D24) |
| Endogenous uncertainty (D89) | Affects equilibrium allocation (D51) |
| Endogenous uncertainty (D89) | Countercyclical labor wedge (E24) |
| Higher firm-level uncertainty during recessions (D89) | Reduced investment (G31) |
| Higher firm-level uncertainty during recessions (D89) | Reduced hiring (J63) |
| Endogenous idiosyncratic uncertainty (D89) | Propagates shocks to financial conditions (E44) |
| Endogenous idiosyncratic uncertainty (D89) | Magnifies response of aggregate activity to monetary and fiscal policies (E62) |
| Fluctuations in confidence (E32) | State-dependent wedges between worst-case belief and econometrician's data generating process (C51) |
| Lower confidence (D81) | Higher labor wedges (J39) |