Uncertainty, Pessimism and Economic Fluctuations

This paper develops a novel theory of uncertainty-driven business cycles that accommodates the notion of non-inflationary aggregate demand shocks out of variations in uncertainty. Instead of thinking uncertainty as risk, we regard uncertainty as ambiguity. We demonstrate that within the real business cycle model, ambiguity shocks, namely shock to the variance of agents' prior belief over possible models, can generate co-movements across real quantities without commensurate movements in labor productivity under the condition that agents are ambiguity averse and there exists a certain type of coordination friction among them. In response to a positive ambiguity, agents behave as if they believe aggregate demand is turning bad and becoming more volatile. The former translates into depressed market confidence, which makes all real quantities plummets. While the latter incentivizes agents use more of their private information both when making economic decisions and forecasts, which heightens the cross-sectional dispersions of beliefs. These predictions regarding agents' belief in our theory are consistent with survey data evidence. Finally, the quantitative potential of our theory is illustrated within a dynamic RBC model.