Learning, Confidence, and Business Cycles

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.

Quantifying Confidence

“…Regarding the second concern, we are open to the idea that our mechanism is proxying for other forces, whose effects are similar to those of the confidence shock but whose micro-foundations remain to be discovered. 21 These points indicate the relation between our paper and recent work that considers other forms of belief distortions, such as Ilut and Saijo (2017), Bhandari, Borovicka, and Ho (2016), and Pei (2017). relative to the frictionless RBC benchmark, a property clearly illustrated by the example in Section 3.3. Consequently, an adverse confidence shock in our setting looks like a negative demand shock in the New Keynesian model.…”

“…There is an emerging literature in this area. Ilut and Saijo (2017) and Angeletos and Lian (2018) considered models that feature a similar kind of belief-driven wedges as the one found here, except that these wedges are allowed to co-vary with conventional structural shocks; this has the interesting implication that a drop in confidence may be triggered by an adverse financial shock, while a boost in confidence may be accomplished by a fiscal stimulus. Huo and Takayama (2015b) obtained quantitative findings that are broadly consistent with ours while maintaining the commonprior assumption.…”

Business Cycle Anatomy

“…Finally, the shock that targets consumption is less tightly connected in terms of variance contributions, but still similar in terms of dynamic comovements.These findings offer support for theories featuring either a single, dominant, business-cycle shock, or multiple shocks that leave the same footprint because they share the same propagation mechanism. With this idea in mind, we use the term "Main Business Cycle shock," or MBC shock, to refer to the common empirical footprint, Beaudry, Galizia, and Portier (2018), Benhabib, Wang, and Wen (2015), Eusepi and Preston (2015), Jaimovich and Rebelo (2009), Huo and Takayama (2015), and Ilut and Saijo (2018). Related is also the earlier literature on coordination failures (Diamond, 1982;Benhabib and Farmer, 1994;Guesnerie and Woodford, 1993).…”

Redistribution and Fiscal Uncertainty Shocks

“…For example, Ilut and Schneider (2014) show that Knightian uncertainty shocks to aggregate TFP can explain a substantial fraction of aggregate fluctuations. For other applications, see Bianchi et al (2017) and Ilut and Saijo (2016). Methodologically, I build on the work by , who develop an algorithm to solve linear, dynamic, heterogeneous agent models with Knightian uncertainty and study the properties of a borrower-lender model.…”