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Ambiguous Business Cycles

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  • Martin Schneider

    (Stanford University)

  • Cosmin Ilut

    (Duke University)

Abstract

This paper considers business cycle models with agents who are averse not only to risk, but also to 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 calls for 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 simple 1st order approximations. In an otherwise standard business cycle model, an increase in ambiguity (that is, a loss of confidence in probability assessments), acts like an 'unrealized' negative news shock: it generates a large recession accompanied by ex-post positive excess returns. Based on an estimated model on US data, we find that ambiguity shocks have the potential to be a major driving source of business cycle fluctuations. The welfare cost of business cycles is then substantially larger than that implied by standard risk-based calculations.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 612.

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Date of creation: 2011
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Handle: RePEc:red:sed011:612

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References

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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper, Federal Reserve Bank of Cleveland 0107, Federal Reserve Bank of Cleveland.
  2. Alejandro Justiniano & Giorgio E. Primiceri & Andrea Tambalotti, 2009. "Investment shocks and the relative price of investment," Staff Reports, Federal Reserve Bank of New York 411, Federal Reserve Bank of New York.
  3. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, Elsevier, vol. 46(2), pages 281-313, October.
  4. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  5. Susanto Basu & Brent Bundick, 2012. "Uncertainty Shocks in a Model of Effective Demand," NBER Working Papers 18420, National Bureau of Economic Research, Inc.
  6. Ruediger Bachmann & Steffen Elstner & Eric R. Sims, 2010. "Uncertainty and Economic Activity: Evidence from Business Survey Data," NBER Working Papers 16143, National Bureau of Economic Research, Inc.
  7. Jes�s Fern�ndez-Villaverde & Juan F. Rubio-Ram�rez, 2007. "Estimating Macroeconomic Models: A Likelihood Approach," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1059-1087.
  8. Marco Cagetti & Lars Peter Hansen & Thomas Sargent & Noah Williams, 2002. "Robustness and Pricing with Uncertain Growth," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 15(2), pages 363-404, March.
  9. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1997-51, Carnegie Mellon University, Tepper School of Business.
  10. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, Econometric Society, vol. 62(2), pages 283-322, March.
  11. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
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  1. Ambiguous Business Cycles
    by Christian Zimmermann in NEP-DGE blog on 2012-06-09 20:57:11
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Cited by:
  1. Mayumi Ojima & Junnosuke Shino & Kozo Ueda, 2014. "Buyer-Size Discounts and Inflation Dynamics," UTokyo Price Project Working Paper Series, University of Tokyo, Graduate School of Economics 017, University of Tokyo, Graduate School of Economics.
  2. Thorsten Drautzburg & Harald Uhlig, 2011. "Fiscal stimulus and distortionary taxation," CQER Working Paper, Federal Reserve Bank of Atlanta 2011-01, Federal Reserve Bank of Atlanta.
  3. Larry G. Epstein & Shaolin Ji, 2013. "Ambiguous volatility and asset pricing in continuous time," Papers 1301.4614, arXiv.org.
  4. Nicholas Bloom, 2013. "Fluctuations in Uncertainty," NBER Working Papers 19714, National Bureau of Economic Research, Inc.
  5. Lars Hansen & Jaroslav Borovicka, 2013. "Robust preference expansions," 2013 Meeting Papers, Society for Economic Dynamics 1199, Society for Economic Dynamics.
  6. Matthew Smith & Rhys Bidder, 2013. "Robust Animal Spirits," 2013 Meeting Papers, Society for Economic Dynamics 265, Society for Economic Dynamics.
  7. Lars Peter Hansen, 2012. "Risk Pricing over Alternative Investment Horizons," Working Papers, Becker Friedman Institute for Research In Economics 2012-008, Becker Friedman Institute for Research In Economics.
  8. Erzo G.J. Luttmer, 2013. "The Stolper-Samuelson effects of a decline in aggregate consumption," Working Papers, Federal Reserve Bank of Minneapolis 703, Federal Reserve Bank of Minneapolis.
  9. David Backus & Axelle Ferriere & Stanley Zin, 2014. "Risk and Ambiguity in Models of Business Cycles," NBER Working Papers 20319, National Bureau of Economic Research, Inc.
  10. Adrian Pagan, 2013. "Patterns and Their Uses," NCER Working Paper Series, National Centre for Econometric Research 96, National Centre for Econometric Research.
  11. Tony Hall & Jan Jacobs & Adrian Pagan, 2013. "Macro-Econometric System Modelling @75," CAMA Working Papers 2013-67, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.

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