Learning, Confidence and Business Cycle

We construct and estimate a 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. This feedback mechanism endogenously generates properties traditionally explained through additional shocks or rigidities: countercyclical labor and financial wedges, co-movement driven by demand shocks, and amplified and hump-shaped dynamics. We find that endogenous idiosyncratic confidence reduces the empirical role of standard rigidities and changes inference about sources of fluctuations and policy experiments.