Learning, Confidence, and Business Cycles

Cosmin Ilut and Hikaru Saijo

No 22958, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: C11 D81 E32 E44 (search for similar items in EconPapers)
Date: 2016-12
New Economics Papers: this item is included in nep-bec, nep-dge and nep-mac
Note: AP EFG ME
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Citations: View citations in EconPapers (11)

Published as Cosmin Ilut & Hikaru Saijo, 2020. "Learning, Confidence, and Business Cycles," Journal of Monetary Economics, .

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Related works:
Journal Article: Learning, confidence, and business cycles (2021)
Working Paper: Learning, Confidence and Business Cycle (2016)
Working Paper: Learning, Confidence, and Business Cycles (2015)
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