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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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  1. Justiniano, Alejandro & Primiceri, Giorgio E. & Tambalotti, Andrea, 2009. "Investment Shocks and the Relative Price of Investment," CEPR Discussion Papers 7598, C.E.P.R. Discussion Papers.
  2. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  3. Marco Cagetti & Lars Peter Hansen & Thomas Sargent & Noah Williams, 2002. "Robustness and Pricing with Uncertain Growth," Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 363-404, March.
  4. Hansen, Lars Peter & Sargent, Thomas J & Tallarini, Thomas D, Jr, 1999. "Robust Permanent Income and Pricing," Review of Economic Studies, Wiley Blackwell, vol. 66(4), pages 873-907, October.
  5. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  6. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  7. Eric R. Sims, 2012. "Uncertainty and Economic Activity: Evidence from Business Survey Data," Working Papers 014, University of Notre Dame, Department of Economics, revised Jun 2012.
  8. Jesus Fernandez-Villaverde & Juan F. Rubio-Ramirez, 2006. "Estimating Macroeconomic Models: A Likelihood Approach," NBER Technical Working Papers 0321, National Bureau of Economic Research, Inc.
  9. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  10. Susanto Basu & Brent Bundick, 2012. "Uncertainty shocks in a model of effective demand," Working Papers 12-15, Federal Reserve Bank of Boston.
  11. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, 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. Thorsten Drautzburg & Harald Uhlig, 2013. "Fiscal stimulus and distortionary taxation," Working Papers 13-46, Federal Reserve Bank of Philadelphia.
  2. Nicholas Bloom, 2014. "Fluctuations in Uncertainty," Discussion Papers 13-033, Stanford Institute for Economic Policy Research.
  3. Larry G. Epstein & Shaolin Ji, 2013. "Ambiguous Volatility and Asset Pricing in Continuous Time," Review of Financial Studies, Society for Financial Studies, vol. 26(7), pages 1740-1786.
  4. Matthew Smith & Rhys Bidder, 2013. "Robust Animal Spirits," 2013 Meeting Papers 265, Society for Economic Dynamics.
  5. Lars Peter Hansen, 2012. "Risk Pricing over Alternative Investment Horizons," Working Papers 2012-008, Becker Friedman Institute for Research In Economics.
  6. Hikaru Saijo, 2013. "The Uncertainty Multiplier and Business Cycles," UTokyo Price Project Working Paper Series 017, University of Tokyo, Graduate School of Economics.
  7. Adrian Pagan, 2013. "Patterns and Their Uses," NCER Working Paper Series 96, National Centre for Econometric Research.
  8. 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.
  9. Erzo G.J. Luttmer, 2013. "The Stolper-Samuelson effects of a decline in aggregate consumption," Working Papers 703, Federal Reserve Bank of Minneapolis.
  10. Lars Hansen & Jaroslav Borovicka, 2013. "Robust preference expansions," 2013 Meeting Papers 1199, Society for Economic Dynamics.

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