NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Learning, Confidence, and Business Cycles

Cosmin L. Ilut, Hikaru Saijo

NBER Working Paper No. 22958
Issued in December 2016
NBER Program(s):AP, EFG, ME

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.

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Document Object Identifier (DOI): 10.3386/w22958

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