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Business Cycles and Endogenous Uncertainty

Author

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  • Ruediger Bachmann

    (University of Michigan and NBER)

  • Giuseppe Moscarini

    (Yale University and NBER)

Abstract

Recessions are times of increased uncertainty and volatility at the micro level. This widely documented empirical pattern has been interpreted as the effect of uncertainty shocks, mediated by various frictions, on aggregate economic activity. We explore the hypothesis that the causation runs the opposite way: first moment shocks induce risky behavior, which in turn raises observed cross-sectional dispersion and time series volatility of individual economic outcomes. Specifically, we study the cyclical pattern of the dispersion of price changes, and the resulting changes in sales and employment at the firm-level. We formulate an imperfect information version of the standard model of monopolistic competition. The elasticity of demand differs across products, and firms are not sure about the elasticity of the demand they face, but learn it from their volume of sales. Due to a fixed operation cost, information is valuable to decide whether to exit the market. Idiosyncratic demand shocks impair learning. The model is fully microfounded and can be aggregated to study general equilibrium. Deviations from average prices are costly to the firm in terms of forgone profits, but the response of sale volumes is informative about market power. Bad economic times are the best times to price-experiment, as the opportunity cost of price mistakes is lower and exit looms large. Following a negative aggregate shock to nominal spending, firms at first keep their prices relatively high, in order to learn whether the demand for their product is sufficiently inelastic and resilient to survive, and then change them further by an amount that depends on what they have learned.

Suggested Citation

  • Ruediger Bachmann & Giuseppe Moscarini, 2011. "Business Cycles and Endogenous Uncertainty," 2011 Meeting Papers 36, Society for Economic Dynamics.
  • Handle: RePEc:red:sed011:36
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    File URL: https://economicdynamics.org/meetpapers/2011/paper_36.pdf
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    References listed on IDEAS

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    1. Berger, David & Vavra, Joseph, 2018. "Dynamics of the U.S. price distribution," European Economic Review, Elsevier, vol. 103(C), pages 60-82.
    2. S. Lael Brainard & David M. Cutler, 1993. "Sectoral Shifts and Cyclical Unemployment Reconsidered," The Quarterly Journal of Economics, Oxford University Press, vol. 108(1), pages 219-243.
    3. Joseph Vavra, 2014. "Inflation Dynamics and Time-Varying Volatility: New Evidence and an Ss Interpretation," The Quarterly Journal of Economics, Oxford University Press, vol. 129(1), pages 215-258.
    4. R?diger Bachmann & Steffen Elstner & Eric R. Sims, 2013. "Uncertainty and Economic Activity: Evidence from Business Survey Data," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(2), pages 217-249, April.
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    Citations

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    Cited by:

    1. Rosen Valchev & Nicolas Vincent & Cosmin Ilut, 2014. "Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty," 2014 Meeting Papers 716, Society for Economic Dynamics.
    2. Robert Ulbricht & Ludwig Straub, 2015. "Endogenous Uncertainty and Credit Crunches," 2015 Meeting Papers 199, Society for Economic Dynamics.
    3. repec:bla:econom:v:84:y:2017:i:336:p:682-711 is not listed on IDEAS
    4. Ambrocio, Gene, 2017. "The real effects of overconfidence and fundamental uncertainty shocks," Research Discussion Papers 37/2017, Bank of Finland.
    5. Ryan A. Decker & Pablo N. D'Erasmo & Hernan Moscoso Boedo, 2016. "Market Exposure and Endogenous Firm Volatility over the Business Cycle," American Economic Journal: Macroeconomics, American Economic Association, vol. 8(1), pages 148-198, January.
    6. N. Bloom., 2016. "Fluctuations in uncertainty," VOPROSY ECONOMIKI, N.P. Redaktsiya zhurnala "Voprosy Economiki", vol. 4.
    7. Cosmin Ilut & Matthias Kehrig & Martin Schneider, 2014. "Slow to Hire, Quick to Fire: Employment Dynamics with Asymmetric Responses to News," Department of Economics Working Papers 150113, The University of Texas at Austin, Department of Economics, revised Dec 2014.
    8. Burkhard Raunig & Johann Scharler & Friedrich Sindermann, 2017. "Do Banks Lend Less in Uncertain Times?," Economica, London School of Economics and Political Science, vol. 84(336), pages 682-711, October.
    9. Leduc, Sylvain & Liu, Zheng, 2016. "Uncertainty shocks are aggregate demand shocks," Journal of Monetary Economics, Elsevier, vol. 82(C), pages 20-35.
    10. Isaac Baley & Julio A. Blanco, 2016. "Menu Costs, Uncertainty Cycles, and the Propagation of Nominal Shocks," Working Papers 918, Barcelona Graduate School of Economics.
    11. repec:lrk:eeaart:36_1_16 is not listed on IDEAS
    12. Marina Riem, 2016. "Corporate investment decisions under political uncertainty," ifo Working Paper Series 221, ifo Institute - Leibniz Institute for Economic Research at the University of Munich.
    13. Julio Blanco & Isaac Baley, 2013. "Learning to Price," 2013 Meeting Papers 663, Society for Economic Dynamics.

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