Learning, Confidence, and Business Cycles∗
Cosmin Ilut
Duke University & NBER

Hikaru Saijo
UC Santa Cruz

February 2016

Abstract
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: countercyclicallabor and financial wedges, co-movement driven by demand shocks, and amplified andhump-shaped dynamics. We find that endogenous idiosyncratic confidence reduces theempirical role of standard rigidities and changes inference about sources of fluctuations
and policy experiments.

1

Introduction

Is firms’ confidence about their business conditions important for understanding aggregate
fluctuations? To answer this question, we construct a heterogeneous-firm business cycle
model in which firms face uncertainty about their own profitability and need to learn it
through production. The learning process generates countercyclical uncertainty that feeds
from, and back into, economic activity. We find that this feedback loop generates properties
that make our model behave as a standard business cycle model with (i) countercyclical laborwedge and financial spread, (ii) positive co-movement of aggregate variables in response toeither supply or demand shocks, and (iii) strong internal propagation with amplified andhump-shaped dynamics.
∗
Email addresses: Ilut cosmin.ilut@duke.edu, Saijo hsaijo@ucsc.edu. We would like to thank Yan Bai,
Nick Bloom, Jesus Fernandez-Villaverde, Tatsuro Senga, Martin Schneider, Mathieu Taschereau-Dumouchel,Carl Walsh, as well as to seminar and conference participants at the ”Ambiguity and its Implications in
Finance and Macroeconomics” Workshop, Bank of England, NBER Summer Institute, Econometric Society
World Congress, San Francisco Fed, Stanford, UC Santa Cruz, SED Annual Meeting, the SITE conference
on Macroeconomics of Uncertainty and Volatility, and Wharton for helpful comments.

1

Traditionally, macroeconomists have employed a variety of shocks and frictions to produce
these key business cycle patterns. For example, labor wedge shocks are commonly cited as
the explanation for the measured countercyclical “wedge” between the marginal rate of
substitution of consumption for labor and the marginal product of labor1 and aggregate
uncertainty shocks are often used to explain the countercyclical excess return of uncertain
assets, such as capital, over the risk free rate.2 Additional rigidities, such as sticky prices
and wages, are usually required to break the Barro and King (1984) critique and make othertypes of shocks, besides productivity or intratemporal labor supply shocks, generate positive
co-movements of macro aggregates. To generate persistent and hump-shaped dynamics,
arbitrary frictions such as consumption habit and investment adjustment costs are often
added to the model. That our model can generate these key properties without relying on
additional shocks or rigidities suggests that endogenous uncertainty could be a parsimonious
mechanism for business cycle models that would at least partially replace these features.
The goal of this paper is to theoretically and quantitatively evaluate this hypothesis.
There are two key ingredients for our mechanism. First, learning occurs through production. In particular, by producing at a larger scale, the firm gets to see more signals
about the business prospects of the firm. We introduce two unobservable shocks into afirm’s production. The first shock is a standard, persistent productivity shock that affects
the marginal return. The second is a transitory shock that does not scale up with the levelof inputs. While what matters for optimal investing and hiring decisions is the realization of
the productivity shock, the path of firm’s output and inputs is not perfectly revealing about
its productivity because it is confounded by the transitory disturbance.
In the model, the level of inputs endogenously determines the informativeness of output
about the idiosyncratic productivity level. Intuitively, when a firm allocates less resources
into production, its estimate about its persistent productivity is imprecise because the levelof output is largely determined by the realization of the transitory shock. Conversely, its
estimate becomes more accurate when it uses more resources because output mostly reflects
the realization of productivity. This results in a procyclical signal-to-noise ratio at thefirm level. It follows that recessions are periods of a high cross-sectional mean of firm-level
uncertainty because firms on average invest and hire less.
The second key ingredient is that uncertainty should matter for the productive inputs.
When firms do not observe their profitability, the optimal choice of inputs is naturally
made under an uncertain evaluation of their return. We model uncertainty as ambiguity,
or Knightian uncertainty. In contrast to models of risk, we can study the effect of Knigh1
2

See Shimer (2009) and Chari et al. (2007) for evidence and discussion of labor wedges.
See Cochrane (2011) for a review of the evidence on countercyclical excess returns.

2tian uncertainty on inputs using linear methods, which in turn facilitates aggregation andestimation. Ambiguity aversion is described by the recursive multiple priors preferences,
axiomatized in Epstein and Schneider (2003b), that capture agents’ lack of confidence inprobability assessments. This preference representation makes agents act as if they evaluate
plans according to a worst case scenario drawn from a set of multiple beliefs. A wider set ofbeliefs corresponds to a loss of confidence.
In our model, ambiguity averse agents cope with estimation uncertainty by first estimating the underlying productivity process using a standard Kalman filter and then considering
a set of probability distributions around the estimates. In particular, when facing a larger
estimation uncertainty, the firm is less confident about the conditional mean of the underlying
persistent profitability. The lower confidence makes the firm behave as if the worst-case mean
becomes worse. This is simply a manifestation of precautionary behavior, which lowers thecertainty equivalent of the return to production, but, compared to risk, has the advantagethat it allows for first-order effects of uncertainty on decisions.
The two ingredients generate a feedback loop at the firm level: lower production leads
to more estimation uncertainty, which in turn shrinks the optimal size of productive inputs.
Importantly, this feedback arises from any shock that starts to move the economic activity.
It may be for example a shock to productivity, to demand or a government spending change.
We show how countercyclical uncertainty shows up as ‘excess volatility’, or wedges, atthe firm level. Specifically, in periods of low production, the estimation uncertainty is larger
and this lowers the worst-case estimate of profitability. As a consequence, the firm lowers
its demand for inputs. From the perspective of the econometrician that measures, under thetrue data generating process, equilibrium objects such as the marginal rate of substitution
between consumption and labor, marginal product of labor or realized return on capital,
these factor demands are excessively low. They can be instead rationalized as labor andinvestment wedges, or taxes on inputs, which, in a reduced form, seem higher in recessions.
Importantly, when uncertainty is modeled as ambiguity with multiple priors that differ
in their mean, the law of large numbers imply that sets of beliefs converge, but that
idiosyncratic uncertainty cannot be diversified away. Intuitively, the agents who do notknow the distribution of firms’ productivity (and hence profit) evaluate choices as if mean
productivity is low. An agent who owns a portfolio of many firms then acts as if theentire portfolio has a low mean payoff. This means that the confidence about idiosyncratic
conditions does not vanish in the aggregate.
The linearity of decision rule is crucial for a tractable aggregation. Indeed, once aggregated, these reduced-form taxes will survive as aggregate countercyclical taxes. The
emergence of the labor wedge is particularly important for the business cycle dynamics.
3

Through it the model is able to generate positive co-movement in aggregate variables, suchas consumption, investment and hours, not only out of productivity shocks, but in generalout of any type of aggregate shock, including demand shocks.
We quantitatively evaluate the role of endogenous uncertainty using a calibrated versionof the baseline model. Our main findings are as follows. First, we find that endogenous
uncertainty is a powerful propagation mechanism. A positive shock that raises economic
activity increases the level of confidence, which in turn further affects economic activity,
leading to an amplified and hump-shaped impulse response.
Second, consistent with the data, our model generates countercyclical labor wedge andex-post excess return. During recessions, ambiguity increases endogenously and thus leads
to an unusually low equilibrium labor supply. The increase in ambiguity also makes capitalless attractive to hold. Investors holding an ambiguous asset are thus compensated by thehigher measured excess return. The countercyclical labor and financial wedges do not arise
from separate labor supply or premia shocks but instead are generated by any underlying
shock that moves economic activity.
Third, the model generates positive co-movements in response to demand shocks. Consider, for example, a positive shock to government spending. In standard RBC models,consumption sharply declines and hours worked rise due to the negative income effect. In
our model, since firms produce more, they become more confident and are willing to hire andinvest more. The higher confidence leads to a positive wealth effect for the representative
agent, who owns the portfolio of firms. This positive effect can be strong enough to overturnthe initial negative one and to make consumption actually rise.
Fourth, firms have an incentive to actively use their productive inputs to learn about theirprofitability. We show that this experimentation incentive has a first-order effect in our setup
and we characterize its cyclical properties. We find that experimentation exerts a procyclicalinfluence on aggregates in the short run, turning experimentation into an amplifying factor,
and a countercyclical one in the medium term, where it dampens fluctuations.
Due to easy aggregation, we can estimate using likelihood based methods quantitativemodels with a large state space, such as Christiano et al. (2005). Our estimated model
includes shocks to aggregate TFP and government spending, as well as a financial wedge
shock, analyzed for example in Christiano et al. (2015). We use standard observables for US
aggregate data: the growth rate of output, hours worked, investment and consumption, as
well as inflation and nominal interest rate. In addition, we use the Baa corporate spread as
an observable proxy, assumed to be measured with error, for the financial wedge shock.
The estimated model provides evidence that endogenous confidence changes significantly
the inference on the role of rigidities and shocks driving fluctuations. In terms of rigidities,4

learning reduces the need of additional frictions for fitting the data. In particular, comparedto the rational expectations (RE) version, the habit formation parameter is lowered by 25%,
the investment adjustment cost becomes negligible, the average Calvo adjustment period ofprices falls from 4 to 2 quarters, and for wages from 25 quarters to 1 quarter. The reason
for these smaller estimated frictions is that the learning mechanism provides strong internal
propagation and induces by itself co-movement in response to the financial wedge shock.
In terms of model comparison, adding endogenous uncertainty allows the model to fit
the data significantly better. The reason is twofold. First, as described above, learning
emerges as a parsimonious friction, as opposed to the array of other rigidities. Second,
while in the RE version the observed spread is mostly accounted as measurement error, themodel-implied spread with learning tracks well the empirical one. This happens because theobserved countercyclical spread is now consistent with co-movement and thus the estimationprefers observed contractionary wedge shocks during recessions. At the same time, agents
lose confidence during recessions, which in our model endogenously contributes further tothe countercyclicality of the spread and improves the model fit.
In the estimated model, endogenous uncertainty changes the propagation mechanism
to the point that the financial wedge shock, disciplined by the observed spread, becomes
an important driver of fluctuations. This illustrates that endogenous confidence can makedemand shocks a relevant source of fluctuations even in the absence of traditionally used
rigidities. At the same time, generating time-variation in uncertainty from an endogenous
mechanism means that policy matters for its evolution. We compare some counterfactualmodels in which a Taylor rule responds to the financial spread to underscore the importanceof modeling a policy-variant uncertainty process.
The paper is organized as follows. In Section 2, we discuss relation to literature. In
Section 3 we introduce our heterogeneous-firm quantitative model. In Section 4 we present
the model’s equilibrium characterization and solution. We discuss the main results basedon a calibrated version in Section 5. In Section 6 we add additional rigidities to estimate amodel using US aggregate data and also also provide some firm-level supportive evidence.

2

Relation to literature

Our paper is related to a rapidly growing literature on time-varying uncertainty. There aremodels that use exogenous increases in the volatility of firm-level productivity to generaterecessions, such as Bloom (2009), Arellano et al. (2012), Bachmann and Bayer (2013),
Christiano et al. (2014), Bloom et al. (2014) and Schaal (2015). Another strand of literature5

analyzes the effects of aggregate uncertainty shocks, such as Fernández-Villaverde et al.
(2011), Basu and Bundick (2012), Bidder and Smith (2012), Born and Pfeifer (2014), Ilutand Schneider (2014), Fernández-Villaverde et al. (2015) and Leduc and Liu (2015). There
are two main differences to this literature. First, we do not rely on additional real or
nominal rigidities to generate contractionary effects of higher uncertainty and positive comovement.3 The reason is that in our model the level of input (such as labor supply) is chosen
under imperfect information, and thus under uncertainty, about the underlying productivity
process. Second, in our economy changes in uncertainty are endogenous and hence affect the
propagation of any aggregate shocks and outcomes of policy experiments.
We differ from other papers in the literature on endogenous uncertainty and learningin business cycles, such as Veldkamp (2005), van Nieuwerburgh and Veldkamp (2006),
Fajgelbaum et al. (2015), Ordoñez (2013), Saijo (2014), in two major aspects. One is that
we focus attention on imperfect information at the idiosyncratic level. We are motivatedby the fact that firm-level volatilities are empirically much larger than fluctuations at theaggregate. This fact suggests that uncertainty about idiosyncratic fundamentals may belarger and hence quantitatively more important than uncertainty about the macro-levelprocess. In addition, because firms learn about their individual-specific characteristics, theimpact of imperfect information is unlikely to be substantially affected by an introductionof market for information or a release of official statistics.4
Our formulation of uncertainty at the firm level has important modeling implications.
First, the additive noise shock has reasonable interpretations at the firm-level. This shock
may arise either as a noisy signal about firm demand or from aggregating productive units
at the firm level.5 Second, our competitive equilibrium is constrained Pareto optimal.
Differently from recent work such as Fajgelbaum et al. (2015) or Ordoñez (2013), this isa model without information externalities since learning occurs at the individual firm leveland not from observing the aggregate economy.6 Third, in our model the firm has anincentive to experiment since it controls the action that produces information. We thus
3

In Angeletos et al. (2014) co-movement is possible, out of correlated higher-order beliefs shocks,
without additional rigidities because labor is assumed to be chosen before observing profitability. Arellano
et al. (2012) also make a similar timing assumption and generate countercyclical labor wedge through anuncertainty shock. In our model the endogenous propagation mechanism makes any type of shock, including
various types of demand shocks, potentially generate labor and financial wedges as well as co-movement.
4
At the same time, our approach can incorporate learning not only about idiosyncratic but also aggregate
conditions, and as such, our results can be viewed as a lower bound on the overall business cycle effects ofendogenous uncertainty.
5
Applying this logic to additive noise about aggregate productivity requires instead additional assumptions on the observability of consumption bundles or the size of the units that are aggregated (see van
Nieuwerburgh and Veldkamp (2006)).
6
For example, the increased economic activity, and the associated average reduction in uncertainty,
produced by a government spending increase can not be welfare increasing in our model.

6

further contribute to the literature on learning by showing how experimentation at the firmlevel affects the equilibrium dynamics of a business cycle model.
The second major difference from the learning literature is that we show that endogenous
confidence not only leads to more persistence and amplification, as in Fajgelbaum et al.
(2015) and Saijo (2014), but that in the process it produces countercyclical endogenous
labor and financial wedges. As a consequence, we contribute to the business cycle literatureby proposing a mechanism that alters the Barro and King (1984) critique of positive comovement of aggregates.7 In addition, this co-movement may now be accompanied bycountercyclical premia, which is a key insight of the asset pricing literature.
We also build on the literature on recursive multiple priors, introduced by Gilboa andSchmeidler (1989), and extended to intertemporal choice by Epstein and Wang (1994) and
Epstein and Schneider (2003b). Ilut and Schneider (2014) and Bianchi et al. (2014) study
tractable business cycle model where time-variation in confidence about aggregate conditions
arises from exogenous ambiguity or volatility shocks. The present paper instead considers
time-variation in confidence about idiosyncratic shocks that emerges entirely endogenously
and which thus changes the propagation mechanism of standard shocks.
Methodologically, this paper develops tractable linear methods to study the effects ofsuch endogenous uncertainty about in a heterogeneous-firm model. An important propertyof the model is that this idiosyncratic uncertainty does not vanish in the aggregate. As such,
this paper is connected to the decision-theoretical literature on the law of large numbers
developed in Marinacci (1999) and Epstein and Schneider (2003a).

3

The model

Our baseline model is a real business cycle model augmented with two key features: Agentsare ambiguity averse and face Knightian uncertainty about the firm-level profitability processes. After presenting the environment, we discuss in detail the information friction thatgives rise to equilibrium fluctuations in confidence.
7

Recent line of attacks to break Barro and King (1984) critique include: heterogeneity in labor supply andconsumption across employed and non-employed (Eusepi and Preston (2015)), variable capacity utilization
together with a large preference complementarity between consumption and hours (Jaimovich and Rebelo(2009)), and the large literature on countercyclical markups through nominal rigidities (such as in thequantitative models of Justiniano et al. (2010) or Christiano et al. (2014)).

7

3.1

Environment

Households
There is a representative household that has recursive multiple priors utility. Collect theexogenous state variables, to be described later, in a vector st ∈ S. A household consumption
plan C gives, for every history st , the consumption of the final good Ct (st ) and the amountof hours worked Ht (st ). For a given consumption plan C, utility is defined recursively by
Ut (C; st ) = ln Ct − ϕ

Ht1+η
+ β mint E p [Ut+1 (C; st , st+1 )],p∈Pt (s )
1+η

(3.1)

where β is the subjective discount factor, ϕ is a scaling parameter that determines hours
worked, and η is the inverse of Frisch labor supply elasticity. Pt (st ) is a set of conditional
probabilities about next period’s state st+1 ∈ St+1 . We specify the evolution of this set insection 3.2.2.8
The household maximizes utility subject to the budget constraintZ
Ct + Bt +ePl,tθl,t dl ≤ Wt Ht + Rt−1 Bt−1 +Ze(Dl,t + Pl,t)θl,t−1 dl + Tt ,where Bt is the one-period risk-free bond, Wt is the real wage, Rt is the risk-free interest
erate, and Tt is a transfer. Dl,t and Pl,t
are the dividend payout and the price of a unit ofshare θl,t of firm l, respectively.
Firms
There is a continuum of firms, indexed by l ∈ [0, 1], which act in a perfectly competitive
manner. They use capital Kl,t−1 , which is utilized at rate Ul,t , and hire labor Hl,t to produce
goods Yl,t according to the production function
Yl,t = At {zl,t (Ul,t Kl,t−1 )α (γ t Hl,t )1−α + γ t νl,t },νl,t ∼ N (0, σν2 ),(3.2)

where γ is the growth rate of labor augmenting technical progress. The scale of theidiosyncratic i.i.d. shock νl,t grows at rate γ, which ensures that the shock does not vanish
8

The recursive formulation ensures that preferences are dynamically consistent. Details and axiomatic
foundations are in Epstein and Schneider (2003b). If the set is singleton we obtain standard separable log
utility with those conditional beliefs. Otherwise, agents are not willing to integrate over the beliefs andnarrow down the set to a singleton. In response, households take a cautious approach to decision making
and act as if the true data generating process is given by the worst-case conditional belief.

8along the balanced growth path. zl,t is an idiosyncratic technology shock that follows9
z,l,t ∼ N (0, σz2 ),zl,t = (1 − ρz )z̄ + ρz zl,t−1 + z,l,t ,(3.3)

and At is an aggregate technology shock that follows
ln At = ρA ln At−1 + A,t ,A,t ∼ N (0, σA2 ).

Firms cannot directly observe the realizations of idiosyncratic shocks zl,t and νl,t . This
informational assumption leads to a non-invertibility problem: Firms cannot tell whether an
unexpectedly high realization of output is due to an increase in individual technology or afavorable transitory disturbance. Instead, they need to form the estimates using all otheravailable information, including the path of output and inputs. In contrast, they perfectly
observe the aggregate shock At .
Firms choose {Ul,t , Kl,t , Hl,t , Il,t } to maximize shareholder value
E0∗

∞
X

M0t Dl,t ,

(3.4)

t=0

where we use E0∗ to denote expectation under the worst case probability. Random variables
M0t denote prices of t-period ahead contingent claims based on conditional worst caseprobabilities and is given by
M0t = β t λt ,where λt is the marginal utility of consumption at time t by the representative household.
Dl,t is the dividend payout given by
Dl,t = Yl,t − Wt Hl,t − Il,t − a(Ul,t )Kl,t−1 ,where Il,t is investment and a(Ul,t ) is the cost of utilization.10 Their capital stock follows thelaw of motion
Kl,t = (1 − δ)Kl,t−1 + Il,t .
9

We assume that the idiosyncratic shock zl,t follows a normal process, a technical assumption that isuseful in solving the learning problem because it makes the information friction linear.
10
We specify: a(U ) = 0.5χ1 χ2 U 2 + χ2 (1 − χ1 )U + χ2 (0.5χ1 − 1), where χ1 and χ2 are parameters. We set
χ2 so that the steady-state utilization rate is one. The cost a(U ) is increasing in the rate of utilization andχ1 determines the degree of the convexity of utilization costs. In a linearized equilibrium, the dynamics arecontrolled by the value of χ1 .

9Interpretation of the additive shock
We generate a procyclical signal-to-noise ratio by adding an unobservable additive shockνl,t to the production function. In Appendix 8.1, we offer an additional interpretation ofthis shock based on noisy demand signals, in which firms learn more about the demandof their goods when they produce and sell more. In that version of the model, firms are
subject to unobservable idiosyncratic shocks to the weight attached to their goods in the
CES aggregator for final goods. It is natural to interpret the shock as a shock to the quality
or demand of goods produced by an individual firm l. The additive shock, which vanishes
in the aggregate due to the law of large numbers, is replaced with an i.i.d. observation errorof the underlying idiosyncratic shock; agents observe noisy signals about the demand, whose
precision is increasing in the level of individual production.
Market clearing and resource constraint
We impose the market clearing conditions for the labor market and the bond market:
Z 1
Ht =

Hl,t dl,

Bt = 0.

0

The resource constraint is given by
Z 1
Ct + It + Gt +a(Ul,t )Kl,t−1 dl = Yt
0

R1
where It ≡ 0 Il,t dl and Gt is the government spending. We assume that the government
R1balances budget each period (Gt = −Tt ). We also assume Gt + 0 a(Ul,t )Kl,t−1 dl = gt Yt
where gt follows
ln gt = (1 − ρg )ḡ + ρg ln gt−1 + g,t ,g,t ∼ N (0, σg2 ).

Timing
The timing of events within a period t is as follows:Stage 1 : Pre-production stage• Agents observe the realization of aggregate shocks (At and gt ).
• Given forecasts about the idiosyncratic technology and its associated worst-casescenario, firms make utilization decisions and hire labor (Ul,t and Hl,t ). The
household supply labor Ht and the labor market clears at the wage rate Wt .
10

Stage 2 : Post-production stage• Idiosyncratic shocks zl,t and νl,t realize (but are unobservable) and production
takes place.
• Given output and input, firms update estimates about their idiosyncratic technology and use it to form forecasts for production next period.
• Firms make investment Il,t and pay out dividends Dl,t . The household makes
consumption and asset purchase decisions (Ct , Bt , and θl,t ).

3.2

Uncertainty and preferences

3.2.1

Learning about idiosyncratic productivity

Firms form estimates about the idiosyncratic shock zl,t from the observables. Since theproblem is linear and Gaussian, Bayesian updating using Kalman filter is optimal fromthe statistical perspective of minimizing the mean square error of the estimates. To ease1−αnotation, we set the trend growth rate γ to zero.11 We denote Fl,t ≡ (Ul,t Kl,t−1 )α Hl,t
. After
production at period t, the measurement equation of the Kalman filter is given by
Yl,t /At = Fl,t zl,t + νl,t ,and the transition equation is given byzl,t = (1 − ρz )z̄ + ρz zl,t−1 + z,l,t .

(3.5)

Note that, unlike the standard time-invariant Kalman filter, the coefficient in the measurement equation, Fl,t , is time-varying.12 The key property of our filtering system is thatthe signal-to-noise ratio is procyclical, which follows from the fact that the input Fl,t isprocyclical. The flip side implication of this property is that uncertainty is countercyclical:
the posterior variance of idiosyncratic technology zl,t rises during recessions. Intuitively, whena firm puts less resources into production, its estimate about its productivity is imprecise
because the level of output is largely determined by the realization of the transitory shock.
Conversely, its estimate is accurate when it uses more resources because output mostly
reflects the realization of productivity.
11

The learning problem of the model with positive growth is provided in Appendix 8.2 along with otherequilibrium conditions.
12
However, also note that, after production, the coefficient is pre-determined, which allows us to use
Kalman filter.

11

To characterize the filtering problem, we start by deriving the one-step-ahead prediction
from the period t − 1 estimate z̃l,t−1|t−1 and its associated error variance Σl,t−1|t−1 . We havez̃l,t|t−1 = (1 − ρz )z̄ + ρz z̃l,t−1|t−1 ,Σl,t|t−1 = ρ2z Σl,t−1|t−1 + σz2 .
Then, given observables (output Yl,t and aggregate productivity At ) firms update theirestimates according toz̃l,t|t = z̃l,t|t−1 + Gainl,t (Yl,t /At − z̃l,t|t−1 Fl,t ),(3.6)

where Gainl,t is the Kalman gain and is given by
2Fl,t
Σl,t|t−1
F −1 .
Gainl,t =2
Fl,tΣl,t|t−1 + σν2 l,t


(3.7)

The updating rule for variance is
Σl,t|t =

σν2
2
Fl,t
Σl,t|t−1 + σν2Σl,t|t−1 .

(3.8)

Intuitively, the error variance is increasing in the un-informativeness of the observation,
which is the variance of noise divided by the total variance. We can see that, holding Σl,t|t−1
constant, the posterior variance Σl,t|t increases as input Fl,t decreases.
The dynamics of the idiosyncratic technology zl,t according to the Kalman filter can thus
be described aszl,t+1 = (1 − ρz )z̄ + ρz (z̃l,t|t + ul,t ) + z,l,t+1 ,(3.9)
where ul,t is the estimation error of zl,t and ul,t ∼ N (0, Σl,t|t ).
3.2.2

Ambiguity

We assume that the representative agent that owns the firms perceives ambiguity about theidiosyncratic shock zl,t . The agent uses observed data to learn about the hidden technology
by using the Kalman filter to obtain a benchmark probability distribution. Ambiguity ismodeled as a one-step ahead set of conditional beliefs Pt (st ) in (3.1), which here consistsof alternative probability distribution surrounding the benchmark controlled by a boundon the relative entropy distance. Thus, our ambiguity-averse agents continue to use theordinary Kalman filter to estimate the latent technology and evaluate plans according to the12worst-case means that are implied by the posterior estimates.
The agent is not confident in the benchmark Kalman filter estimate z̃l,t in (3.9) andconsiders a set of probability distributions, of the form
zl,t+1 = (1 − ρz )z̄ + ρz z̃l,t|t + µ∗l,t+1 + ρz ul,t + z,l,t+1 ,(3.10)

where µl,t+1 ∈ [−al,t , al,t ]. From the perspective of the agent, a change in posterior variancetranslates into a change in uncertainty about the one-step-ahead realization of technology.
As in Bianchi et al. (2014), the change in uncertainty, in turn, affects the set of possibleµl,t+1 and thus the worst-case mean.
More precisely, agents only consider the conditional means µ∗l,t+1 that are sufficiently
close to the long run average of zero in the sense of relative entropy:(µ∗l,t+1 )2
1 2
η ,
≤
2ρ2z Σl,t|t
2 a(3.11)

where the left hand side is the relative entropy between two normal distributions that sharethe same variance ρ2z Σl,t|t , but have different means (µ∗l,t+1 and zero), and ηa is a parameterthat controls the size of the entropy constraint. Agents compare the normal distributions
with variance ρ2z Σl,t|t because we assume that they only treat the estimation error ut asambiguous. They are fully confident in the law of motion in equation (3.5) and treat thetechnology shock z,l,t+1 as risk. The relative entropy can be thought of as a measure of
distance between the two distributions. When uncertainty Σl,t|t is high, it becomes difficult
to distinguish between different processes. As a result, agents become less confident andcontemplate wider sets µl,t+1 of conditional probabilities.
The worst-case belief can be easily solved for at the equilibrium consumption plan: theworst-case expected idiosyncratic productivity is low. In particular, equation (3.11) implies
that the worst-case mean is given by−al,t = −ηa ρzp
Σl,t|t .

(3.12)

Thus, the agent’s cautious behavior faced with the set Pt (st ) of beliefs results in acting as if
the conditional mean of each firm’s idiosyncratic technology is given by the worst-case meanin (3.12). We denote conditional moments under these worst case belief by stars.
We make two additional remarks. The first concerns the role of experimentation. In
Bayesian decision making, experimentation is valuable because it raises expected utility by
improving posterior precision. Ambiguity-averse agents also value experimentation since it
affects utility by tightening the set of conditional probability considered. In our model,
13

firms take into account the impact of the level of input on worst-case mean when they
make decisions. Although we allow active learning by firms, our model can still be solved
using standard linear methods. When we present our quantitative results, we assess thecontribution of experimentation by comparing our baseline results with those under passive
learning, i.e. where agents do not actively experiment.
The second remark is to note that the shareholder value, under which firms take optimal
decisions in equation (3.4), depends on the worst case expectations E0∗ . This is because
state prices reflect the representative household’s ambiguity. An important feature is that,
unlike the case of risk, the idiosyncratic uncertainty that shows up in these state prices does
not vanish under diversification. Uncertainty affects ambiguity-averse household’s utility bylowering the worst-case mean and hence the household acts as if the mean of each individual
firm’s technology is lower. As a result, ambiguity is not diversified away in the aggregate
and uncertainty lowers the mean of the expected aggregate technology.13

4Equilibrium characterization and solution

We start by discussing the recursive representation of the model. We then build on theframework to describe the solution method we use to solve for the equilibrium law of motion.
Finally, we characterize the endogenous wedges that arise from equilibrium fluctuations in
uncertainty.

4.1

Recursive competitive equilibrium

As in Angeletos et al. (2014), it is useful to divide the agents’ problem into two stages;
stage 1 (pre-production stage) and stage 2 (post-production stage). To ease exposition,
we abstract from utilization momentarily. We collect exogenous aggregate state variables(such as aggregate TFP) in a vector X with a cumulative transition function F (X 0 |X).
The endogenous aggregate state is the distribution of firm-level variables. A firm’s type isidentified by the posterior mean estimate of productivity z̃l , the posterior variance Σl , and its
capital stock Kl . The worst-case TFP is not included because it is implied by the posteriormean and variance. We denote the cross-sectional distribution of firms’ type by ξ1 and ξ2 .
ξ1 is a stage 1 distribution over (z̃l , Σl , Kl ) and ξ2 is a stage 2 distribution over (z̃l0 , Σ0l , Kl ).
13

See Marinacci (1999) or Epstein and Schneider (2003a) for formal treatments of the law of large numbers
for i.i.d. ambiguous random variables. There they show that sample averages must (almost surely) lie in
an interval bounded by the highest and lowest possible mean, and these bounds are tight in the sense thatconvergence to a narrower interval does not occur.

14ξ10 , in turn, is a distribution over (z̃l0 , Σ0l , Kl0 ) at stage 1 in the next period.14
First, consider the household’s problem. The household’s wealth can be summarized by→−a portfolio θl which consists of share θl for each firm and the risk-less bond holdings B. We
use V1h and V2h to denote the household’s value function at stage 1 and stage 2, respectively.
We use m to summarize the income available to the household at stage 2. The household’s
problem at stage 1 is

H 1+η
∗
h
ˆ
−ϕ
+ E [V2 (m̂; ξ2 , X)]
1+η
Z
s.t. m̂ = W H + RB + (D̂l + P̂l )θl dl→−
V1h ( θl , B; ξ1 , X) = max
H



(4.1)

where we momentarily use the hat symbol to indicate random variables that will be resolved
at stage 2. The household’s problem at stage 2 isV2h (m; ξ2 , X) =



Z

max

ln C + βZ0s.t. C + B + Pl θl0 dl ≤ m−→C, θl 0 ,B 0→−V1h ( θl 0 , B 0 ; ξ10 , X 0 )dF (X 0 |X)(4.2)

ξ10 = Γ(ξ2 , X)
In problem (4.1), households choose labor supply based on the worst-case stage 2 value (recall
that we use E ∗ to denote worst-case conditional expectations). The problem (4.2), in turn,describes the household’s consumption and asset allocation problem given the realization ofincome and aggregate states. In particular, they take as given the law of motion of the next
period’s distribution ξ10 = Γ(ξ2 , X), which in equilibrium is consistent with the firm’s policy
function. Importantly, in contrast to the stage 2 problem, a law of motion that describes theevolution of ξ2 from (ξ1 , X) is absent in the stage 1 problem. Indeed, if there is no ambiguityin the model, agents take as given the law of motion ξ2 = Υ(ξ1 , X), which in equilibrium isconsistent with the firm’s policy function and the true data generating process of the firmlevel TFP. Since agents are ambiguous about each firm’s TFP process, they cannot settle
on a single law of motion about the distribution of firms. Finally, the continuation value atstage 2 is governed by the transition density of aggregate exogenous states X.
Next, consider the firms’ problem. We use v1f and v2f to denote the firm’s value function
14

See also Senga (2015) for a recursive representation of an imperfect information heterogeneous-firmmodel with time-varying uncertainty.

15

at stage 1 and stage 2, respectively. Firm l’s problem at stage 1 isv1f (z̃l , Σl , Kl ; ξ1 , X) = max E ∗ [v2f (z̃ˆl0 , Σ0l , Kl ; ξˆ2 , X)]
Hl

(4.3)

s.t. Updating rules (3.6) and (3.8)
and firm l’s problem at stage 2 isv2f (z̃l0 , Σ0l , Kl ; ξ2 , X) = max
Il



Z
f 0
0
0
0 0
0
λ(Yl − W Hl − Il ) + β v1 (z̃l , Σl , Kl ; ξ1 , X )dF (X |X)(4.4)

s.t. Kl0 = (1 − δ)Kl + Il
ξ10 = Γ(ξ2 , X)

where we simplify the exposition by expressing a firm’s value in terms of the marginal utility
λ of the representative household. Similar to the household’s problem, a firm’s problem atstage 1 is to choose the labor demand so as to maximize the worst-case stage 2 value. Notethat the posterior mean z̃l0 will be determined by the realization of output Yl at stage 2 while
the posterior variance Σ0l is determined by Σl and the input level at stage 1. In problem(4.4), the firm then chooses investment taking as given the realization of output and the
updated estimates of its productivity. Note that, as in the household’s problem, firms takeas given the (equilibrium) law of motion of the distribution of firms in the stage 2 problem
but not in the stage 1 problem.
The discussion above highlights one of the key features of our model; the level of labor
input is chosen before the realization of firm-level productivity and that this timing arises
naturally from imperfect information about the underlying productivity process. This
labor-in-advance feature allows us to circumvent the Barro and King (1984) critique andhence generate feedback effects of time-varying uncertainty consistent with business cycle
co-movement without additional rigidities.
We conclude this subsection by providing a brief definition of the recursive competitive
equilibrium of our model. The recursive competitive equilibrium is a collection of valuefunctions, policy functions, and prices such that
1. Households and firms optimize; (4.1) – (4.4).
2. The labor market, goods market, and asset markets clear.
3. The law of motion ξ10 = Γ(ξ2 , X) is induced by the firms’ policy function Il (z̃l0 , Σ0l , Kl ; ξ2 , X).

16

4.2

Log-linearized solution

We solve for the equilibrium law of motion using standard log-linear methods. This is possible
for two reasons. First, since the filtering problem firms face is linear, the law of motion of
the posterior variance can be characterized analytically (Saijo (2014)). Because the levelof inputs has first-order effects on the level of posterior variance, linearization captures theimpact of economic activity on confidence. Second, we consider ambiguity about the meanand hence the feedback from confidence to economic activity can be also approximatedby linearization. In turn, log-linear decision rules facilitate aggregation because the crosssectional mean becomes a sufficient statistic for tracking aggregate dynamics.
We follow Ilut and Schneider (2014) and solve for the equilibrium law of motion using aguess-and-verify approach:(a) guess the worst case beliefs p0 .
(b) solve the model assuming that agents have agents have expected utility and beliefs p0 .
(c) compute the agent’s value function V .
(d) verify that the guess p0 indeed achieves the minima.
In what follows we explain step (b) by deriving log-linearized expressions for the expected
worst-case output at stage 1 and the realized output at stage 2.15 We use the example toillustrate that uncertainty about the firm-level TFP has a first-order effect at the aggregate.
We first find the worst-case steady state by evaluating a deterministic version of thefiltering problem and standard first-order conditions under the guessed worst-case belief.
Potential complications arise because the worst-case TFP depends on the level of economic
activity. Since the worst-case TFP, in turn, determines the level of economic activity, there
could be multiple steady states. We circumvent this multiplicity by treating the posteriorvariance of the level of idiosyncratic TFP as a parameter and by focusing on the steady statethat is implied by that posterior variance.
Next, we log-linearize the model around the worst-case steady state. To do this, we firstlog-linearize the expected worst-case output of individual firm l at stage 1:
00
Et∗ Ŷl,t0 = Ẑt0 + Et∗ ẑl,t+ F̂l,t,(4.5)

and the realized output of individual firm l at stage 2:00Ŷl,t0 = Ẑt0 + ẑl,t+ F̂l,t,15

We provide a general description of the procedure in Appendix 8.3.

17

(4.6)

where we use x̂0t = xt − x̄0 to denote log-deviations from the worst-case steady state andset the trend growth rate γ to zero to ease notation. The worst-case individual output(4.5) is the sum of three components: the current level of aggregate TFP, the worst-caseindividual TFP, and the input level. The realized individual output (4.6), in turn, is thesum of aggregate TFP, the realized individual TFP, and the input level.
We then aggregate the log-linearized individual conditions (4.5) and (4.6) to obtain the
cross-sectional mean of worst-case individual output:
Et∗ Ŷt0 = Â0t + Et∗ ẑt0 + F̂t0 ,(4.7)

and the cross-sectional mean of realized individual output:
Ŷt0 = Â0t + ẑt0 + F̂t0 ,

(4.8)

R1
where we simply eliminate subscript l to denote the cross-sectional mean, i.e., x̂0t ≡ 0 x̂0l,t dl.
So far we have characterized the dynamics of output under the worst-case scenario. Our
final step is to characterize the dynamics under the true data generating process (DGP). To
do this, we feed in the cross-sectional mean of individual TFP, which is constant under thetrue DGP, into (4.7) and (4.8). Using (4.7), the cross-sectional mean of worst-case output isgiven byEt∗ Ŷt = Ât + Et∗ ẑt + F̂t ,(4.9)
where we use x̂t = xt − x̄ to denote log-deviations from the steady-state under the true DGP.
Using (4.8), the realized aggregate output is given byŶt = Ât + F̂t ,(4.10)

where we used ẑt = 0 under the true DGP. Importantly, Et∗ ẑt in (4.10) is not necessarily zero
outside the steady state. To see this, combine (3.10) and (3.12) and log-linearize to obtainan expression for Et∗ ẑl,t :Et∗ ẑl,t = εz,z z̃ˆl,t−1|t−1 − εz,Σ Σ̂l,t−1|t−1 .

(4.11)

From (3.8), the posterior variance is negatively related to the level of input F :Σ̂l,t−1|t−1 = εΣ,Σ Σ̂l,t−2|t−2 − εΣ,F F̂l,t−1 ,(4.12)The elasticities εz,z , εz,Σ , εΣ,Σ , and εΣ,F are functions of structural parameters and are all18

positive. We combine (4.11) and (4.12) to obtainEt∗ ẑl,t = εz,z z̃ˆl,t−1|t−1 − εz,Σ εΣ,Σ Σ̂l,t−2|t−2 + εz,Σ εΣ,F F̂l,t−1 .

(4.13)

Finally, we aggregate (4.13) across all firms:
Et∗ ẑt = −εz,Σ εΣ,Σ Σ̂t−2|t−2 + εz,Σ εΣ,F F̂t−1 ,(4.14)

R1
where we used 0 z̃ˆl,t−1|t−1 dl = 0.16
Notice again that the worst-case conditional cross-sectional mean simply aggregates
linearly the worst-case conditional mean, −al,t , of each firm. Since the firm-specific worstcase means are a function of idiosyncratic uncertainty, which in turn depend on the firms’
scale, equation (4.14) shows that the average level of economic activity, F̂t−1 , has a first-ordereffect on the cross-sectional average of the worst-case mean. For example, this means thatduring recessions, firms on average produce less, which leads to lower confidence about theirfirm-level TFP. This endogenous reduction in confidence further reduces equilibrium hours
worked and other economic activity.

4.3

Wedges from uncertainty

Co-movement and the labor wedge
Endogenous uncertainty leads to co-movement and a countercyclical labor wedge. This canbe analyzed by considering the optimal labor tradeoff of equating the marginal cost to the
expected marginal benefit under the worst-case belief Et∗
ϕHtη = Et∗ (λt M P Lt )(4.15)In the standard model, there is no expectation on the right-hand side. As emphasized byBarro and King (1984), there hours and consumption move in opposite direction unless there
is a TFP or a labor supply shock (a shock to ‘ϕ’).
Instead, in our model, there can be such co-movement. Suppose that there is a periodof low confidence. From the negative wealth effect there is a low consumption, so thestandard effect would be to see high labor supply as a result of the high marginal utility of
consumption λt . However, because the firm chooses hours as if productivity is low, there isa counter substitution incentive for hours to be low.
16

This follows from aggregating the log-linearized version of (3.6) and evaluating the equation under thetrue DGP. Intuitively, since the cross-sectional mean of idiosyncratic TFP is constant, the cross-sectionalmean of the Kalman posterior mean estimate is a constant as well.

19

To see how the model generates countercyclical labor wedge, note that an increase in ambiguity due to a reduction in labor supply looks, from the perspective of an econometrician,like an increase in the labor income tax. The labor wedge can now be easily explained by
implicitly defining the labor tax τt as
ϕHtη = (1 − τt )λt M P Lt
Using the optimality condition in (4.15), the labor tax is
τt = 1 −Et∗ (λt M P Lt )λt M P L t(4.16)

Consider first the linear rational expectations case. There the role of idiosyncratic
uncertainty disappears and the labor tax in equation (4.16) is constant and equal to zero.
The reason is that our timing assumption that labor is chosen after the aggregate shocks
are realized and observed at the beginning of the period makes the optimality condition in(4.15) take the usual form of an intratemporal labor decision.17
In our model, the role of idiosyncratic uncertainty does not vanish and instead it shows up
in the as if expected return to working, formed under the worst-case belief Et∗ . Thus, even
if labor is chosen after aggregate shocks are realized and observed, the average idiosyncratic
uncertainty has a first-order effect on the cross-sectional average of the worst-case mean, as
detailed in section 4.2.
Consider now the econometrician that measures realized hours, consumption and themarginal product of labor as of time t. While agents take the labor decision under Et∗ , theeconometrician measures these equilibrium objects under the data generating process whichuses the average µ = 0. The difference between the worst-case distribution and the averagerealization under the econometrician’s data generating process produces a labor wedge,
which, in log-linear deviations, is inversely proportional to the time-varying confidence.
In a period of low confidence, the ratio between the expected benefit to working under the
worst-case belief compared to the econometrician’s measure of λt M P Lt is typically lower.
Thus the econometrician rationalizes the ‘surprisingly low’ labor supply by a high labor tax τt .
In turn, the low confidence is generated endogenously from a low level of average economic
activity, as reflected in the lower cross-sectional average of the worst-case mean, as given
17

If we would assume that labor is chosen before the aggregate shocks are realized, there would be afluctuating labor tax in (4.16) even in the rational expectations model. In that model, the wedge is τt = 1 −Et−1 (λt M P Lt ), where, by the rational expectations assumptions, Et−1 reflects that agents form expectations
λt M P Lt
using the econometrician’s data generating process. Crucially, in such a model, the labor wedge τt will not
be predictable using information at time t − 1, including the labor choice, such that Et−1 τt = 0. In contrast,
our model with learning produces predictable, countercyclical, labor wedges.

20

by equation (4.14). Thus, the econometrician will find a systematic negative relationshipbetween economic activity and the labor income tax. This relationship is consistent with
empirical studies that suggest that in recessions labor falls by more than what can be
explained by the marginal rate of substitution between labor and consumption and themeasured marginal product of labor (see for example Shimer (2009) and Chari, Kehoe, andMcGrattan (2007)). This countercyclical labor wedge does not arise from separate labor
supply shocks but instead it is generated by any underlying shock that moves labor supply.
Finally, for an ease of exposition, we have described here the behavior of the labor wedge
by ignoring the potential effect of experimentation on the optimal labor choice. This effectadds an additional reason why labor moves ‘excessively’, from the perspective of an observerthat only uses equation (4.15) to understand labor movements. As discussed in section 5.2,
experimentation amplifies the effects of uncertainty during the short-run, and thus leads toeven more variable labor wedges, while it dampens fluctuations in the medium-run.
Excess return
A similar logic applies to the countercyclical ex-post excess return. The Euler conditions forcapital and risk-free assets stateK
λt = βEt∗ [λt+1 Rt+1
] = βEt∗ [λt+1 Rt ]K
K
Under our linearized solution, Et∗ Rt+1
= Rt , where Et∗ Rt+1
is the expected return on
capital under the worst-case belief. During low confidence times, demand for capital will beKunder the true
‘surprisingly low’. This is rationalized by the econometrician, measuring Rt+1
K
− Rt . In the linearized solution, the excess return,
DGP, as a high ex-post excess return Rt+1
similarly to the labor tax, is inversely proportional to the time-varying confidence. In timesof low economic activity, when confidence is low, the measured excess return is high.
Thus, the model can generate a countercyclical labor wedge at times when the measured
premia on uncertain assets is high.18 This arises from any type of shock that moves the
economic activity.

5

Quantitative results

We are interested in studying the role of endogenous firm-level uncertainty in business cycles.
In this section we evaluate the empirical performance of the calibrated version of our model
18

The pricing logic can be extended to defaultable corporate bonds. This will likely generate countercyclicalexcess bond premia, as documented for example by Gilchrist and Zakrajšek (2012).

21

Table 1: Parameters for the calibration exercise
γ
1.004

α
0.3

β
0.99

η
0

δ
0.025

χ1
0.15

ηa
0.4

Σ̄
0.1

ḡ
0.2

ρz
0.5

σz
0.4

ρA
0.95

ρg
0.95

and contrast its quantitative implications with those of a standard RBC model. We find theparsimony of this model a useful laboratory for the purpose of facilitating comparison withthe standard RBC paradigm. We perform a more ambitious quantitative exercise in Section
6, where we introduce further nominal and real rigidities and estimate the model using alikelihood-based method.

5.1

Parameterization

Table 1 summarizes the parameters used in our exercise. In order to facilitate comparisonof our model with a standard RBC model, we use common values used in the literature
whenever possible.
The magnitude of the feedback loop between uncertainty and economic activity isdetermined by three factors. The first factor is the variability of inputs which is determinedby the elasticities of labor supply and capital utilization. Regarding the labor supply
elasticity, it is well known that standard real business cycles models understate the volatilityof hours compared to the data. Motivated by this tension, we set the inverse Frisch elasticity
η equal to zero following the indivisible labor model by Hansen (1985) and Rogerson (1988).
We set the parameter that relates utilization rate to depreciation (χ1 ) so that in equilibrium
utilization rate is slightly less volatile than output.19
Second, the parameters that are related to the idiosyncratic processes control how changes
in inputs translate to changes in the posterior variance. We choose ρz = 0.5 and σz = 0.4
for the idiosyncratic TFP process. Idiosyncratic TFP is less persistent than the aggregate,
which is in line with the finding in Kehrig (2015). The values imply a cross-sectional standard
deviation of TFP of 0.46 and is in line with the estimates found in Bloom et al. (2014)
using the establishment-level data. Recall from the Discussion in section 4.2 that we reparameterize the model so that we take the worst-case steady state posterior variance Σ̄0of idiosyncratic TFP as a parameter. This posterior variance, together with ρz and σz , will
pin down the standard deviation of the additive shock σν . David et al. (2015) estimate theposterior variance of a firm-specific shock (in the context of our model, a TFP shock) to19

In the data, the standard deviation of the capacity utilization index, provided by the Federal Reserve
Board of Governors, is more than twice as the standard deviation of GDP.

22

be around 8–13%. We choose the worst-case steady state posterior variance so that at thezero-risk steady state the posterior variance Σ̄ is 10%.20
Finally, the size of the entropy constraint ηa determines how changes in the posteriorvariance translate into changes in confidence. To gauge the size of ambiguity that agentsface, we use the cross-sectional mean of the dispersions of firm-level capital return forecasts
across analysts from the Institutional Brokers’ Estimate System (I/B/E/S) data. Specifically,
we compute the min-max range of forecasts, defined as (max-min)/mean, for each firms andtake the cross-sectional average.21 For example, if there are three analysts for a firm X andthe analyst 1’s return on capital forecast is 8%, the analyst 2’s forecast is 10%, and theanalyst’s forecast is 12%, then this will deliver a min-max range of 40%.22 Averaged acrossthe period 1985–2014, the cross-sectional mean of min-max range of forecasts is 43%. The
model counterpart of the min-max range by analysts is the cross-sectional mean of min-max
range of the capital return forecast implied by the set of productivity process (3.10) at thezero-risk steady state, where the minimum forecast is based on the worst-case mean µ∗l = −al
and the maximum forecast is based on the best-case mean µ∗l = al . We set ηa = 0.4, which
generates the steady-state min-max range of forecasts of 39%.23
Our parameterization implies that the cross-sectional mean of the worst-case individual
TFP at the zero-risk steady state is about 94 percent of the actual realized level. The Kalman
gain at the zero-risk steady state, normalizing the level of input to one, is 0.47. To put thisin perspective, the gain implies that an observation from quarters ago will receive a weight(1 − 0.47)4 ≈ 0.08. Thus, learning is fairly precise and quick under our parameterization.

5.2

Impulse response analysis

Figure 1 plots the impulse response to a positive TFP shock.24 In addition to the response
from the baseline model (labeled ‘Baseline’), we also report the responses from the modelwith passive learning (labeled ‘Passive’), in which the firm does not internalize the effectof its input choice on its future uncertainty, and the standard rational expectation (RE)RBC model (labeled ‘RE’). The solution to the RE model is obtained by simply setting
20

The zero-risk steady state is the ergodic steady state of the economy where optimality conditions take
into account uncertainty and the data is generated under the econometrician’s DGP. Appendix 8.3 provides
additional details.
21
We are grateful to Tatsuro Senga for providing us the statistics.
22
During 1985–2014, the average number of firms sampled each year is 1460 and the average number ofanalysts surveyed for each firm is 9.8 in the I/B/E/S data set.
23
Larger ambiguity leads to a higher min-max range of the capital return forecasts. For example, setting
ηa = 0.3, holding other parameters fixed, generates a min-max range of 29% and ηa = 0.5 generates a 50%
range. Ilut and Schneider (2014) argue that a reasonable upper bound for ηa is 2, based on the view thatagents’ ambiguity should not be “too large”, in a statistical sense, compared to the variability of the data.
24
We show the response to 0.1% increase in TFP.

23

Figure 1: Impulse response to an aggregate TFP shock

Percent deviation

OutputInvestment
8

2

6
4

1

2
0

0
5

10

15

20

5

Consumption

10

15

20

15

20

Hours

0.16

2

0.14
1

0.12
0.1
0.08

0
5

10

15

20

5

Labor wedge

10

Ex−post excess return
0

0
−0.02
−0.04

−0.5

−0.06
−0.08

−1
5

10

15

20

5

Cross−sectional mean of worst−case TFP
0.06
0.04

10

15

20

Cross−sectional mean of realized TFP
1Baseline
Passive
0
RE

0.02
0
5

10

15

−1

20

5

10

15

20

Notes: Thick black solid line is our baseline model with active learning, thin blue dashed line is the modelwith passive learning, and thick red dashed line is the frictionless, rational expectations, RBC model.

24Figure 2: Impulse response to a government spending shock

Percent deviation

OutputInvestment
1.5

0.6

1

0.4

0.5
0.2

0
5

10

15

20

5

Consumption
0.6

0

0.4

−0.01

0.2
10

15

20

15

20

Hours

0.01

5

10

15

20

5

Labor wedge

10

Ex−post excess return

0
−0.1

−0.01

−0.2

−0.02

−0.3
5

10

15

20

5

Cross−sectional mean of worst−case TFP
0.02
0.01
0

5

10

15

15

20

Cross−sectional mean of realized TFP
1Baseline
Passive
0
RE

−1

20

10

5

10

15

20

Notes: Thick black solid line is our baseline model with active learning, thin blue dashed line is the modelwith passive learning, and thick red dashed line is the frictionless, rational expectations, RBC model.

25the entropy constraint ηa to zero. In this case, agents think in terms of single probabilities
and the model reduces to a rational expectation model. Note that when ηa = 0, firm-level
learning cancels out in the aggregate due to linearization and the law of large numbers.
Compared to the RE version, our model generates amplified and hump-shaped response in
output, investment, and hours. These dynamics are due to the endogenous variation in firms’
confidence. In response to a positive TFP shock, firms (on average) increase their inputs,
such as hours and the capital utilization rate. The increase in inputs lowers uncertainty
which implies that firms contemplate a narrower set of conditional probabilities; the worstcase scenarios become less worse. As a result, the agent acts as if the mean idiosyncratic
productivities are higher and this may further stimulate economic activity. At the sametime, from the perspective of the econometrician, labor supply and the demand for capitalare surprisingly high. Thus, both labor wedge and ex-post excess return on capital decline.
Finally, we compare our baseline impulse response with the response from the passive
learning model. Initially the output and hours responses of the baseline model with active
learning are larger than those of passive learning. In the medium run, however, the responsesof passive learning become larger. This is due to a dynamic interaction of two opposing
forces. On one hand, higher production during booms increases the value of experimentation
because it raises the marginal benefit of an increase in the expected worst-case technology.
On the other hand, there is an offsetting effect coming from a reduction in posterior variance.
Since the level of posterior variance is downward convex in the level of inputs, the marginal
reduction in posterior variance due to an increase in inputs is smaller during booms. During
the initial period of a positive technology shock, the first effect dominates the second. As
the economy slows down, the second effect becomes more important.
Figure 2 shows the impulse response to a 1% increase in government spending. In thestandard RBC model, due to the negative wealth effect hours increase but consumption
decline. In our model, an increase in government spending, due to its effects of raising hours
worked, also raises firms’ confidence, which further stimulates economic activity. As a result,output, hours, and investment increases are larger. The negative response of consumption
is overturned after five periods due to the positive income effect generated by the increasein confidence. Thus, a demand shock, such as the government spending shock may lead topositive comovement in consumption and labor.

5.3

Business cycle moments

Table 2 reports the HP-filtered second moments. To facilitate comparison with the standard
RBC model, we assume that the only source of aggregate disturbance is the TFP shock.

26

Table 2: HP-filtered moments
Data Our modelStandard deviations
σ(y)
1.11
1.11
σ(c)/σ(y)0.72
0.05
σ(i)/σ(y)3.57
3.40
σ(h)/σ(y)1.64
1.00Correlations with labor wedge
σ(y, τl )
-0.83
-0.98
σ(h, τl )
-0.97
-0.98
Autocorrelations
σ(yt , yt−1 )
0.89
0.88
σ(∆yt , ∆yt−1 ) 0.39
0.49

RE
0.41
0.09
3.40
0.92
0
0
0.68
-0.05

Notes: Both data and model moments are in logs, HP-filtered (λ = 1600) if the variables are in levels, andmultiplied by 100 to express them in percentage terms. The model moments are the median values from
200 replications of simulations of 120 periods (after throwing away the initial 50 periods). The sample
period for the data is 1985Q1–2014Q4. We choose the standard deviation of the aggregate TFP shock sothat the output standard deviation in the baseline model matches the data. The government spending
shock is set to zero.

First, with endogenous uncertainty the output standard deviation is more than twice
larger than the RE version. The baseline model is also successful in generating a larger
standard deviation of hours relative to output. The low volatility of hours has been a major
shortcoming of RBC theories. Our model is less successful in reproducing the volatilities ofconsumption and investment. Second, our model can replicate the strong negative correlationof economic activity and the labor wedge. Third, our model gives a closer match in terms of
autocorrelations. The baseline model generates higher autocorrelations in levels and, more
importantly, positive autocorrelations in growth rates of output. As pointed out by Cogley
and Nason (1995) and Rotemberg and Woodford (1996), a standard RBC model cannot
generate persistence in output growth due to its weak internal propagation mechanism.

6

Empirical investigation:

Bayesian estimation andfirm-level evidence
In the previous section, we investigated the quantitative potential of endogenous uncertainty
using a calibrated version of the model. In this section, we embed the learning mechanism

27

into two DSGE models and conduct Bayesian likelihood estimations on US data. We ask two
main questions. First, does endogenous uncertainty still play a key role when conventional
rigidities are introduced? In turn, how important are those conventional rigidities when ourlearning mechanism is in place? Second, how does endogenous uncertainty affect inference
about the source of business cycles and outcomes of policy experiments? We conclude thesection by providing some firm-level data that supports the key implication of our model.

6.1

Models with conventional rigidities

We estimate two DSGE models: a flexible-price and a sticky-price model. In the flexibleprice model, we augment the baseline model introduced in the previous section with tworeal rigidities. Specifically, we modify the representative household’s utility (3.1) to allow
for habit persistence in consumption:
Ht1+η
+ β mint E p [Ut+1 (C; st , st+1 )],Ut (C; s ) = ln(Ct − bCt−1 ) − ϕp∈Pt (s )1+ηtwhere b > 0 is a parameter, and introduce an investment adjustment cost into the capital
accumulation equation:2 κ Il,t−γIl,t ,
Kl,t = (1 − δ)Kl,t−1 + 1 −2 Il,t−1(6.1)

where κ > 0 is a parameter.
In the sticky-price model, in addition to the consumption habit and investment adjustment cost, we consider Calvo-type price and wage stickiness along with monopolisticcompetition.25 We assume a Taylor-type reaction function by the central bank:
Rt
=
R̄



Rt−1
R̄

ρR 

πt
π̄

φπ 

Yt
Ȳ

φY 1−ρRR,t ,

2
R,t ∼ N (0, σR,t),where π̄ is the inflation target, R̄ = π̄γ/β, and Ȳ is output along the balanced growth path.
ρR , φπ , and φY are parameters and R,t is a monetary policy shock.
25

To avoid complications arising from directly embedding infrequent price adjustment into firms, we follow
Bernanke et al. (1999) and assume that the monopolistic competition happens at the “retail” level. Retailers
purchase output from firms in a perfectly competitive market, differentiate them, and sell them to final-goods
producers, who aggregate retail goods using the conventional CES aggregator. The retailers are subject to
the Calvo friction and thus can adjust their prices in a given period with probability 1 − ξp . To introduce
sticky wages, we assume that households supply differentiated labor services to the labor packer with a CES
technology who sells the aggregated labor service to firms. Households can only adjust their wages in a given
period with probability 1 − ξw .

28

Finally, we introduce a “financial wedge” shock ∆kt to agents’ Euler equation for capital
accumulation (Christiano et al. (2015)):k,
1 = (1 − ∆kt )Et∗ Mt+1 Rt+1
kis the return on capital. We assume the process for ∆kt :where Mt+1 ≡ M0t+1 /M0t and Rt+1

¯ k + ρ∆ ∆k + ∆,t ,∆kt = (1 − ρ∆ )∆t−12
∆,t ∼ N (0, σ∆).

Combining the Euler equation for the risk-free asset, 1 = Et∗ Mt+1 Rt , with that for capitalk−Rt . As discussed in Christiano et al.
accumulation and rearranging, we obtain ∆kt ' Et∗ Rt+1
(2015), the financial wedge could reflect variations in costs of financial intermediation suchas bankruptcy costs or changes in the desirability of corporate bonds due to, for example,
liquidity concern. In addition, our model generates the wedge through endogenous variationin confidence. We include the financial wedge shock because of a wide perception that
financial frictions played a key role during the Great Recession. Our main focus is to explore
how endogenous uncertainty affects the propagation of the financial wedge shock.

6.2

Bayesian estimation

Because the aggregate law of motion is linear, we can use standard Bayesian techniques
as described in An and Schorfheide (2007) to estimate the model. The sample period is
1985Q1–2014Q4. The data is described in Appendix 8.5. For the flexible-price model, thevector of observables are[∆ ln Yt , ∆ ln Ht , ∆ ln It , ∆ ln Ct , Spreadt ],where Spreadt is the Baa corporate bond yield relative to the yield of Treasury bond withten-year maturity.26 We assume that the model counterpart of Spreadt is the excess-returnon capital so that Spreadt = Rtk − Rt−1 .27 For the sticky-price model, we add inflation and26
27

We also used the spread constructed in Gilchrist and Zakrajšek (2012) and obtained similar results.
To understand what causes variations in the spread, it is useful to decompose it into three components:
0

0

∗
∗
Spreadt = (Et−1
Rtk − Rt−1 ) + (Rtk − Et Rtk ) + (Et Rtk − Et−1
Rtk ),
0(6.2)

where we use Et to use worst-case expectations at the end of stage 1 (after the realization of period t aggregate
shock but before the realization of idiosyncratic shocks). The financial wedge shock ∆kt causes variationsin the first component, changes in confidence cause variations in the second component, and innovations toaggregate shocks (such as TFP shocks) cause variations in the third component.

29the Federal funds rate to the observables:[∆ ln Yt , ∆ ln Ht , ∆ ln It , ∆ ln Ct , ln πt , ln Rt , Spreadt ].
We fix a small number of parameters prior to estimation. The depreciation rate ofcapital δ is set to 0.025. The steady-state share of government spending to output is0.2. We set θp and θw so that the steady-state price and wage markups are both 10%.
The prior distributions for other structural parameters are collected in Table 3 and 4. For
most parameters, we choose relatively loose priors. We reparametrize the parameter that
determines the size of ambiguity (ηa ) and instead estimate 0.5ηa . We set a Beta prior for
0.5ηa , centered around the calibrated value in the previous section, so that the lowest value
corresponds to rational expectations and the highest value corresponds to the upper boundηa = 2 suggested by Ilut and Schneider (2014). Since all our estimation exercises have lessstructural shocks than observables, we add i.i.d. measurement error to observables except for
the interest rate. At the posterior mean, measurement error explains 1 percent of variationof a particular observable while at one standard deviation it explains 5 percent.28

6.3

Results

Parameter estimates
Table 3 and 4 report the posterior distributions of the two models (labeled ‘Baseline’). For
comparison, we also report estimates of the rational expectations versions of the models(labeled ‘RE’). Two key results emerge. First, aggregate data prefers sizable amount of
ambiguity. The posterior estimates of the parameter that determines the size of the entropy
constraint, ηa , are 1.24 and 1.32 for flexible-price and sticky-price models, respectively. The
posteriors imply that agents contemplate a set of conditional means whose bounds are given
by roughly ±1 standard deviations around the benchmark Kalman filter estimate.
Second, when we allow for endogenous ambiguity, the estimated degrees of real andnominal rigidities are smaller than in the rational expectations versions. In the sticky-pricemodel, the Calvo probability of not being able to adjust the price decreases from ξp = 0.76
to ξp = 0.56 and the Calvo wage probability decreases from ξw = 0.96 to ξw = 0.02. To
put these into perspective, in the RE version of the model, prices are adjusted on average
every 1/(1 − 0.76) ≈ 4 quarters and wages are adjusted every 1/(1 − 0.96) = 25 quarters. In
contrast, in our baseline model prices are adjusted every 1/(1 − 0.56) ≈ 2 quarters and wages
are adjusted roughly every quarter. Compared to the RE version, the estimated frequency of
28

The only exception to this is a measurement error for the spread; at one standard deviation it explains
20 percent of the variation.

30

Table 3: Estimated parameters: preference, technology, and policy

Prior

100(γ − 1)

Growth rate

Type
N

Mean
0.5

Std
0.3

100(β −1 − 1)

Discount factor

G

0.25

0.05

100(π̄ − 1)
α
η
χ1
b
κ
ξp
ξw
ρR
φπ
φY
ρz

Net inflation
Capital share
Inverse Frisch elasticity
Utilization cost
Consumption habit
Investment adj. cost
Calvo priceCalvo wage
Interest smoothing
Inflation response
Output response
Idiosyncratic TFP

N
B
G
G
B
G
B
B
B
N
N
B

0.5
0.3
1

0.3
0.05
0.4

0.7
0.4
3

0.3
0.1
2

0.5
0.5
0.7
1.5
0.1
0.5

0.2
0.2
0.1
0.15
0.05
0.05

Posterior mode
Flexible price
Sticky priceBaseline
RE
Baseline
RE
0.48
0.47
0.57
0.34
[0.42, 0.55][0.39, 0.56][0.50, 0.62]

1.01

1.01

0.27

0.19

[0.15, 0.34][0.13, 0.26]––

Idiosyncratic TFP

G

0.4

0.1

Entropy constraint

B

0.2

0.1

0.25

0.41

0.33

[0.21, 0.33][0.33, 0.45][0.28, 0.38]

0.38

0.03

0.26

0.79

[0.23, 0.55][0.01, 0.08][0.14, 0.39][0.89, 2.13]

0.46

0.08

0.22

1.27

[0.24, 0.85][0.04, 0.23][0.16, 0.31][0.42, 2.00]

0.53

0.40

0.47

0.62

[0.34, 0.65][0.27, 0.53][0.38, 0.62][0.49, 0.71]

0.00

0.09

0.06

0.30

[0.00, 0.00][0.07, 0.21][0.05, 0.08][0.20, 0.49]

–

–

–
–
–
–
0.62

–
–
–
–
–

0.80
0.62

SS posterior variance

G

0.1

0.05

0.05
[0.03, 0.11]

0.56

0.76

[0.52, 0.59][0.71, 0.80]

0.02

0.96

[0.00, 0.03][0.94, 0.97]

0.57

0.35

[0.53, 0.64][0.28, 0.45]

1.91

2.10

[1.77, 2.12][1.88, 2.28]

0.07

0.00

[0.06, 0.08][-0.01, 0.00]

0.62

–

[0.57, 0.65]

–

0.83

0

0.66

0

[0.60, 0.80]–

0.12[0.03, 0.24]

Notes: B refers to the Beta distribution, N to the Normal distribution, G to the Gamma distribution, IG
to the Inverse-gamma distribution. 95% posterior intervals are in brackets and are obtained from 200,000
draws using the random-walk Metropolis-Hasting algorithm.

31–[0.72, 0.92][0.46, 0.72]

Σ̄

0.45
[0.17, 0.80]

0.19[0.68, 1.11]

0.5ηa

0.72
[0.58, 0.82][0.14, 0.31][0.46, 0.72]

σz[0.26, 0.43]–

Table 4: Estimated parameters: shocks and measurement errors

Prior

ρA

Aggregate TFP

Type
B

Mean
0.6

Std
0.2

ρg

Government spending

B

0.6

0.2

ρ∆
100σA
100σg
100σ∆
100σR
100σY
100σH
100σI
100σC
100σspread
100σπFinancial wedge
Aggregate TFPGovernment spending
Financial wedge
Monetary policy
Meas. error output
Meas. error hours
Meas. error investm.
Meas. error consum.
Meas. error spread
Meas. error inflation

B
IG
IG
IG
IG
IG
IG
IG
IG
IG
IG

0.6

0.2

1

1

1

1

0.1

1

0.1

1

0.060

0.13

0.073

0.16

0.18

0.40

0.050

0.11

0.018

0.08

0.024

0.11

Log marginal likelihood

Posterior mode
Flexible price
Sticky priceBaseline
RE
Baseline
RE
0.98
0.99
0.93
0.93
[0.93, 1.00][0.99, 1.00][0.89, 0.95]

0.70

0.28

0.94

0.70

[0.21, 0.95][0.12, 0.88][0.72, 0.99][0.26, 0.96]

0.53

0.27

0.98

0.94

[0.44, 0.62][0.09, 0.59][0.94, 1.00][0.91, 0.95]

0.28

0.35

0.22

0.26

[0.23, 0.35][0.26, 0.43][0.19, 0.27][0.22, 0.34]

0.50

0.78

0.90

0.44

[0.34, 0.94][0.37, 1.01][0.72, 1.10][0.29, 0.67]

0.10

0.03

0.05

0.06

[0.09, 0.12][0.02, 0.04][0.04, 0.06][0.05, 0.07]

–

–

32

0.04

0.03

[0.03, 0.05][0.02, 0.04]

0.29

0.03

0.45

0.32

[0.11, 0.40][0.02, 0.32][0.40, 0.54][0.22, 0.37]

0.44

0.56

0.58

0.39

[0.38, 0.53][0.46, 0.62][0.47, 0.62][0.33, 0.47]

1.07

0.99

1.21

1.06

[0.86, 1.32][0.79, 1.16][1.08, 1.39][0.91, 1.26]

0.41

0.35

0.39

0.33

[0.35, 0.47][0.31, 0.42][0.33, 0.44][0.29, 0.40]

0.01

0.20

0.01

0.28

[0.00, 0.03][0.18, 0.24][0.01, 0.05][0.26, 0.34]

–

–

2336

Notes: See notes for Table 3.

[0.90, 0.96]

2262

0.23

0.28

[0.19, 0.25][0.25, 0.33]

3489

3413

Figure 3: Estimated impulse response to a financial wedge shock in the flexible-price model

Percent deviation

OutputInvestment
0

0

−0.5

−0.1

−1
−0.2

−1.5

−0.3

Baseline
RE counterfactual

−2
5

10

15

20

5

Consumption

10

15

20

15

20

Hours

0.04

0

0.02

−0.1

0
−0.2

−0.02

−0.3

−0.04
−0.06

−0.4
5

10

15

20

5

10

Notes: Black solid line is the baseline impulse response and the red dashed line is the response where we
set the entropy constraint ηa = 0 while holding other parameters at their estimated values.

price change is thus more in line with the micro evidence presented in Bils and Klenow (2004).
The degree of consumption habit decreases by 25% (b = 0.62 to b = 0.47) and the investment
adjustment cost falls from κ = 0.3 to κ = 0.06. In the flexible-price model, while consumption
habit slightly increases with endogenous uncertainty, the investment adjustment cost falls
from κ = 0.09 to zero.29
Propagation of the financial wedge shock
We argue that the reason why our model requires smaller rigidities than the RE version
is because our learning mechanism provides strong internal propagation and induces comovement in response to the financial wedge shock.
To understand this, Figure 3 shows the estimated impulse response to a financial wedge
shock in the flexible-price model. In addition to the baseline impulse response (labeled ‘Baseline’), we also display the response for a version of the model in which we set ηa = 0 and freeze
29

The intuition for the increase in the habit parameter in the flexible-price model is as follows. As we willsee below, while endogenous uncertainty induces co-movement in response to a financial wedge shock in themedium run, consumption moves in the opposite direction in the short run. Because in our baseline flexibleprice model the financial wedge shock accounts for a non-trivial variation of consumption, the estimation
tries to mitigate this initial negative co-movement by increasing the habit. In the sticky-price model, suchforce is absent because all quantities move in the same direction from the initial period.

33

Figure 4: Estimated impulse response to a financial wedge shock in the sticky-price model

Percent deviation

OutputInvestment

−0.5

−2

−1
−4
−1.5

Baseline
RE counterfactual

−6
−2
5

10

15

20

5

Consumption

10

15

20

15

20

Hours

0

−0.2

−0.2

−0.4

−0.4

−0.6

−0.6
−0.8

−0.8

−1

−1
5

10

15

20

5

10

Notes: See notes for Figure 3.

the remaining parameters to the baseline estimated values (labeled ‘RE counterfactual’). In
the baseline, output, investment, and hours falls but consumption increase in the short run.
In the medium-run, however, consumption also falls because of the decline in confidence. At
the same time, the model generates hump-shaped dynamics even though the estimated real
rigidities are small. In the RE counterfactual, on the other hand, consumption and othervariables move in the opposite direction and the impulse response is monotonic.30
Figure 4 shows that similar forces are at work in the sticky-price model. However, allquantities fall immediately because countercyclical markups provide an additional wedgethat breaks the Barro and King (1984) critique. At the same time, our model requires
less nominal rigidities because endogenous uncertainty partly acts as a substitute to thecountercyclical markups in generating co-movement.
Model fit
The final row of Table 4 reports the log marginal likelihoods, computed by the Geweke’s
modified harmonic mean estimator, across different model specifications. For both flexible30

A different way to evaluate the impact of our learning mechanism is to examine the impulse response in
the RE model, in which the parameters are re-estimated subject to the constraint ηa = 0. We find that themodel is still unable to produce co-movement.

34

Table 5: Fit of observables
Model

Statisticσ(data)Panel A: Flexible priceBaseline σ(model)ρ(data, model)RE
σ(model)ρ(data, model)
Panel B: Sticky priceBaseline σ(model)ρ(data, model)RE
σ(model)ρ(data, model)

Output
0.60

Hours
0.73

Investment
1.79

Consumption
0.50

Inflation
0.24

Spread
0.18

0.60
0.94
0.60
1.00

0.45
0.83
0.30
0.76

1.21
0.86
1.43
0.87

0.21
0.62
0.28
0.77

–
–
–
–

0.18
1.00
0.04
-0.37

0.60
0.75
0.57
0.92

0.40
0.69
0.58
0.88

1.20
0.82
1.17
0.86

0.33
0.67
0.35
0.80

0.19
0.53
0.32
0.52

0.18
1.00
0.25
0.19

Notes: σ(data) and σ(model) refer to standard deviations of the observables and the model counterparts,
respectively, expressed in percentage points. ρ(data, model) is the correlation between data and the model.

price and sticky-price models, the model fit, measured in terms of log marginal likelihoods,
is improved when our endogenous uncertainty mechanism is activated. To understand thisresult, in Table 5 we report the summary statistics of our observables and their model
counterparts at the posterior mean, computed by the Kalman smoothing algorithm. The
fit of endogenous variables except for the spread in the baseline flexible-price and stickyprice models is similar to the RE versions. The last column of Panel A shows that while
the baseline flexible-price model perfectly matches the movement of the spread, in the RE
version the model generates less than a quarter of the variation and it is negatively correlatedwith data. Panel B shows that the baseline sticky-price model also perfectly reproduces the
movement of the spread. In contrast, the fit is much worse in the RE version. Indeed, Table
4 shows that measurement errors for spreads are much larger in the RE versions for both
flexible-price (0.20 vs. 0.01) and sticky-price (0.28 vs. 0.01) models.
Figure 5 visualizes this result by plotting the spread along with the flexible-price model
counterpart computed from the Kalman smoother. The model-implied spread, labeled‘Baseline’, tracks the data while the spread from the RE model, labeled ‘RE’, does not.
There are two reasons for the success of our baseline model. First, with endogenous
uncertainty the financial wedge shock can now generate co-movement and thus the estimationprefers contractionary wedge shocks during recessions. Second, agents lose confidence during
recessions, which further contribute to the countercyclicality of the spread. This endogenous

35

Figure 5: Credit spread: data and model
1.3
Data

Quarterly percentage points

1.2
1.1

BaselineRE
1
0.9

Baseline(ambiguity only)

0.8
0.7
0.6
0.5
0.4
1985

1990

1995

2000

2005

2010

Notes: We plot the Baa corporate bond spread along with the flexible-price model counterpart computedfrom the Kalman smoother. Thick black solid line is the data, thin blue line (marked with x) is the spreadfrom the baseline model, thick red dashed line is the spread generated by endogenous variation in
confidence, and thin green dashed line is the spread from the rational expectations model.

variation in the spread is labeled ‘Baseline (ambiguity only)’.31 The plot of the spreads
from the sticky-price model (not shown) also shows a similar pattern. We conclude thatthe ability of our model to generate countercyclical spreads, due to the financial wedge
shock being countercyclical and the endogenous variation in confidence, is the key reason
the estimation favors our learning mechanism.
Variance decomposition
To see how the introduction of endogenous uncertainty alters inference about the source ofbusiness cycles, Table 6 reports the contributions of TFP and financial wedge shocks. Panel
A shows the variance decomposition for the flexible-price model. In the RE version, the TFPshock accounts for almost all variations of macro variables. In contrast, in our baseline model,
the financial wedge shock explains a non-trivial fraction of business cycles since the shock can
now generate co-movement; it accounts for 14 and 16 percents of volatilities in output andhours, respectively. Panel B shows that, with nominal rigidities, the financial wedge shockaccounts for a sizable fraction of variations in quantities even in the RE version. For example,
31

This endogenous variation in the spread corresponds to the second component in the previous
decomposition of the spread (6.2).

36

Table 6: Theoretical variance decomposition
Model
Shock
Panel A: Flexible priceBaseline TFPFinancial wedge
RE
TFP
Financial wedge
Panel B: Sticky priceBaseline TFPFinancial wedge
RE
TFP
Financial wedge

Output

Hours

Investm.

Consum.

Inflation

Interest rate

0.86
0.14
0.99
0.00

0.84
0.16
0.98
0.01

0.83
0.16
0.99
0.01

0.92
0.08
1.00
0.00

–
–
–
–

–
–
–
–

0.27
0.73
0.84
0.15

0.18
0.81
0.77
0.23

0.20
0.76
0.88
0.12

0.38
0.61
0.78
0.22

0.09
0.88
0.12
0.88

0.16
0.84
0.10
0.90

Notes: We report the percent of variance at the business cycle frequency (6–32 quarters) that can be
explained by each shock. For the interest of space, we omit the percent of variance explained bygovernment spending and monetary policy shocks.

the shock explains 15 and 23 percents of variations in output and hours, respectively. With
endogenous uncertainty, however, the financial wedge shock becomes the dominant sourceof the business cycle. For example, the shock now explains 73 and 81 percents of variations
in output and hours, respectively. The financial wedge shock accounts for a large share ofvariation in inflation and interest rates for both the baseline and the RE models.
In Appendix 8.4, we show that the inclusion of the spread in the estimation is the key
reason why in our model the financial wedge shock becomes an important driver of thebusiness cycle. Intuitively, the financial wedge shock needs to be large since the spread isvolatile and countercyclical. Without endogenous uncertainty, however, this comes at thecost of generating counterfactual predictions for other macro variables.
Policy implications of endogenous uncertainty
Finally, the fact that in our model uncertainty is endogenous has important policy implications. To illustrate this point, we evaluate the impact of modifying the Taylor rule toincorporate an adjustment to the credit spread.32 Table 7 reports the standard deviation of
output growth as we maintain all parameters as their baseline estimated values but change
the Taylor rule coefficient on the credit spread φspread from the original value of zero in
the estimated sticky-price model. The standard deviation decreases as the monetary policy
responds more aggressively to the spread movements. For example, the standard deviation
32

Such a policy was proposed by Taylor (2008), among others. Cúrdia and Woodford (2010) and Christiano
et al. (2010) study the effects of similar policies using DSGE models.

37

Table 7: Changing the Taylor rule coefficient on the credit spreadφspread
0
-0.5
-1.0
-1.5

Std. of output growthBaseline Fixed uncertainty
0.60
0.60
0.59
0.60
0.57
0.60
0.52
0.63

Notes: The standard deviation of output growth as the Taylor rule coefficient on the credit spread φspread ischanged from the original value (φspread = 0). All other parameter values are fixed to the estimated values.
“Baseline” refers to the baseline sticky-price model with endogenous uncertainty. “Fixed uncertainty”
refers to a counterfactual economy where the path of uncertainty is fixed exogenously to the original one.

decreases from 0.60 to 0.52 when the coefficient φspread decreases from 0 to −1.5.
The reduction in output variability comes from stabilizing the endogenous variation in
uncertainty. To see this, we also show the effects of policy changes in the counterfactual
economy where the path of uncertainty is fixed to the original one (labeled “Fixed uncertainty”). In this economy, changes in φspread have smaller effects and even have a different
sign. Indeed, the standard deviation increases from 0.60 to 0.63 when the coefficient φspreaddecreases from 0 to −1.5. The comparison of these counterfactual models underscores theimportance for policy analysis of modeling time-variation in uncertainty as an endogenous
response that in turn further affects economic decisions.

6.4

Firm-level evidence

The estimated business cycle model with conventional rigidities suggests that endogenous
countercyclical idiosyncratic uncertainty may be an important propagation mechanism at
the aggregate level. We conclude our empirical investigation by changing focus and report
some cross-sectional evidence.
Our theory predicts that, through learning, a larger scale of production leads to lower
uncertainty. We use here firm-level data to test this prediction. We use panel data ofanalysts’ forecast error on each firm’s return on capital from the I/B/E/S data. The data
set spans annually from 1977–2014 and is constructed in Senga (2015).33 We define eachfirm’s forecast errors as (realized return - mean forecast)/mean forecast. We proxy the scaleof production by the size of total assets held by each firm. Our hypothesis is that, cross33

We thank Tatsuro Senga for conducting and sharing the analysis in this section and for numerous advice
on the data set.

38

Table 8: Forecast errors are smaller for larger firms
Percentile
Mean error
Median error

0–10
0.93
0.35

10–25
0.62
0.21

25–50 50–75
0.51
0.38
0.16
0.12

75–90
0.32
0.09

90–1000.25
0.08

Notes: The table reports the cross-sectional mean (second row) and the cross-sectional median (third row)of the forecast errors on capital returns, grouped according to the total asset held by each firm.

Table 9: Forecast errors are smaller for older firms
Age
Mean error
Median error

1–10 11–20
0.65 0.40
0.22 0.13

21–30
0.30
0.10

31–
0.27
0.08

Notes: The table reports the cross-sectional mean (second row) and the cross-sectional median (third row)of the forecast errors on capital returns, grouped according to the age. We proxy firm age by the number ofyears since the firm’s first year of appearance in the I/B/E/S data set.

sectionally, the size of forecast errors are smaller the larger the scale of production. Table 8
documents that the data provides empirical support for our hypothesis.
We also consider a test that is more loosely connected to our theory. Our theory builds on
the idea that firms learn about their fundamentals through production, suggesting that old
firms face less uncertainty. Indeed, in Table 9, we show that the forecast error are smaller for
older firms. While our model does not feature entry and exit and hence cannot directly speak
to the relationship between firm age and uncertainty, the result in Table 9 is encouraging as
it provides suggestive evidence for our learning mechanism.
Finally, we point out that the time-series implications of our model are supported by thedata as well. Our theory predicts that the cross-sectional average of uncertainty increases
during recessions. Senga (2015) shows that the average level of capital return forecast errors
across firms is strongly countercyclical and rose sharply during the Great Recession.

7

Conclusion

In this paper we construct a tractable heterogeneous-firm business cycle model in whichfirms face Knightian uncertainty about their own profitability and need to learn it through39

production. The feedback loop between economic activity and confidence makes our model
behave as a standard linear business cycle model with (i) countercyclical labor wedge andfinancial spread, (ii) positive co-movement of aggregate variables in response to either supply
or demand shocks, and (iii) strong internal propagation with amplified and hump-shaped
dynamics. When the model is estimated using US data, our learning process drives out therole of traditional rigidities and changes inference about the source of aggregate fluctuations
and outcomes of policy experiments. We conclude that endogenous idiosyncratic uncertainty
is a quantitatively important mechanism for understanding business cycles.

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43

8

Appendix (For online publication)

8.1

A model of learning about firm-specific demand

In this section, we show that the baseline model with additive shock in the production
function (3.2) can be reinterpreted as a model where firms learn about their demand fromnoisy signals.
There is a continuum of firms, indexed by l ∈ [0, 1], which produce intermediate goods
and sell them to a large representative “conglomerate”. The conglomerate, who holds
shares of the intermediate firms, acts in a perfectively competitive manner and combine
the intermediate goods to produce final goods. To ease exposition, we momentarily abstractfrom all aggregate shocks, labor-augmenting technological growth, and utilization.
The conglomerate combines intermediate output Yl,t according to the following CES
aggregator:
σ
Z 1
 σ−1
σ−1
σ−1
zl,tσ Yl,t σ dl
Yt =
,
σ>1
0

where zl,t follows an AR(1) as in (3.3). In turn, intermediate goods Yl,t are produced
according to1−ααYl,t = Kl,t−1
Hl,t.
We assume that all agents, including the conglomerate and households, cannot observe therealization of zl,t . Instead, after the production of final and intermediate goods they observe
noisy signals
sl,t = Yl,t zl,t + ν̃l,t ,ν̃l,t ∼ N (0, σν̃2 )(8.1)
where ν̃l,t is an observation error. Agents use all available information, including the pathof signals sl,t and intermediate output Yl,t , to form estimates about the realization of zl,t .
In this context, it is natural to think zl,t as a “quality” of intermediate good l that isdifficult to observe. Alternatively, since the final good could directly be used for consumption,
zl,t can be interpreted as an unobservable demand for a variety l. Crucially, (8.1) implies
that the signal-to-noise ratio is increasing in the level of output Yl,t . It is plausible thatfirms learn more about the quality or demand, zl,t , of their goods when they produce andsell more. For example, when a restaurant serves more customers it generates more website
reviews and hence people learn more about the quality of their meals.
Intermediate firms l choose price Pl,t and inputs to maximize the shareholder value
E0∗

∞
X

M0t Dl,t .

t=0

44

Dl,t is the dividend payout to the conglomerate given by
Dl,t =

Pl,t
Yl,t − Wt Hl,t − Il,t ,Ptwhere Pt is the price of the final good given by
Z 1
Pt =

1−σ
Pl,t
dl

1
 1−σ

.

0

The conglomerate, in turn, choose intermediate inputs Yl,t and shares θl,t to maximize theshareholder value∞X
E0∗
M0t Dt ,t=0

where Dt is the dividend payout to the householdsZ
D t = Yt +e
(Dl,t + Pl,t)θl,t−1 dl −

Z

e
Pl,t
θl,t dl.

The household side of the economy is the same as in the baseline model except that thehouseholds hold shares θt of conglomerates instead of shares θl,t of intermediate firms.
We now reintroduce aggregate shocks and utilization and describe the timing of the eventat period t.
Stage 1 : Pre-production stage• Agents observe the realization of aggregate shocks (At and gt ).
• Given forecasts about zl,t and its associated worst-case scenario, firms make utilization decision, hire labor, and choose price (Ul,t , Hl,t , and Pl,t ). The household
supply labor Ht and the labor market clears at the wage rate Wt .
• Firms produce intermediate output Yl,t and sells it to the conglomerates at price
Pl,t .
Stage 2 : Post-production stage• zl,t realize (but are unobservable) and production of the final goods Yt takes place.
Agents observe noisy signals sl,t .
• Firms and conglomerates update estimates about zl,t and use it to form forecasts
for production next period.

45• Firms make investment Il,t and pay out dividends Dl,t to the conglomerates. The
conglomerates make asset purchase decisions θl,t and pay out dividends Dt to thehouseholds. Finally, households make consumption and asset purchase decisions(Ct , Bt , and θt ).
In the perfect competition limit (σ → ∞), this version of the model is observationallyequivalent to the baseline model at the aggregate level. The introduction of the conglomerate
is important for two reasons. First, it prohibits households from inferring zl,t from utility
by directly consuming intermediate goods Yl,t . Second, it generates countercyclical ex-post
excess return on equity held by the household. This is because dividend payout by theconglomerate to the household (Dt ) is based on the realized return on capital. Note thatthe dividend payout by the intermediate firms to the conglomerate (Dl,t ) is not based on therealized return since the production and market clearing of Yl,t happens before the realizationof zl,t .

8.2

Equilibrium conditions for the estimated model

As we describe below in Appendix 8.3, we express equilibrium conditions from the perspectiveof agents at both stage 1 and stage 2. At stage 1, we need not only equilibrium conditions
for variable determined before production (such as utilization and hours), but also those forvariables determined after production (such as consumption and investment). At stage 2,
we treat variables determined before production as pre-determined. To do this, we index
period t variables determined at stage 1 by t − 1 and period t variables determined at stage
2 by t. We then combine stage 1 and stage 2 equilibrium conditions by using the certainty
equivalence property of linearized decision rules.
We scale the variables in order to introduce stationary:
ct =

Yl,t
Kl,t−1Il,tFl,t−1
Wt
Ct, yl,t = t , kl,t−1 =, il,t = t , fl,t =, wt = t , λ̃t = γ t λt , µ̃l,t = γ t µl,t ,
t
t
t
γ
γ
γ
γ
γ
γ

where µl,t is the Lagrangian multiplier on the capital accumulation equation of firm l.
We first describe the stage 1 equilibrium conditions. An individual firm l’s problem is tochoose {Ul,t , Kl,t , Hl,t , Il,t } to maximize
Et∗

∞
X

W
β t+s λt+s [Pt+s
Yl,t+s − Wt+s Hl,t+s − Il,t+s − a(Ul,t+s )Kl,t+s−1 ],s=0where PtW is the price of whole-sale goods produced by firms and λt , and its detrended46

counterpart λ̃t , is the marginal utility of the representative household:
λ̃t =

γ
1
− βbEt∗,ct − bct−1
γct+1 − bct(8.2)

subject to the following three constraints. The first constraint is the production function:∗yl,t = At {Et−1zl,t fl,t + νl,t },

(8.3)

1−α
fl,t = (Ul,t kl,t−1 )α Hl,t
.

(8.4)

where fl,t is the input,

The worst case TFP Et∗ zl,t+1|t+1 is given by
Et∗ zl,t+1|t+1 = (1 − ρz )z̄ + ρz z̃l,t|t − ηa ρzp
Σl,t|t .

(8.5)

and the Kalman filter estimate z̃l,t|t evolves according toz̃l,t|t = z̃l,t|t−1 + Gainl,t (yl,t /At − z̃l,t|t−1 fl,t ),(8.6)

where Gainl,t is the Kalman gain and is given by
2
fl,t
Σl,t|t−1
Gainl,t = 2
f −1 .
fl,t Σl,t|t−1 + σν2 l,t


(8.7)

The second constraint is the capital accumulation equation:
2 κ γil,t−γil,tγkl,t = (1 − δ)kl,t−1 + 1 −2 il,t−1(8.8)

and the last constraint is the law of motion for posterior variance:
Σl,t|t = (1 − Gainl,t fl,t )Σl,t|t−1 .

(8.9)

As described in the main text, firms take into account the impact of their input choice on
worst-case probabilities.
The first-order necessary conditions for firms’ input choices are as follows:47• FONC for Σl,t|t


1
−1
W
λ̃t+1 Pt+1
At+1 ηa ρz Σl,t|t2 fl,t+122
σν2 ρ2z (ρ2z Σl,t|t + σz2 )fl,t+1
σν2 ρ2z+ ψl,t+1 2,− 2
fl,t+1 (ρ2z Σl,t|t + σz2 ) + σν2 {fl,t+1(ρ2z Σl,t|t + σz2 ) + σν2 }2

ψl,t =βEt∗(8.10)

where ψl,t is the Lagrangian multiplier for the law of motion of posterior variance.
• FONC for Ul,tλ̃t PtW α22ασν2 (ρ2z Σl,t−1|t−1 + σz2 )fl,tyl,t+ ψl,t 2 2Ul,t{fl,t (ρz Σl,t−1|t−1 + σz2 ) + σν2 }2 Ul,t(8.11)=λ̃t {χ1 χ2 Ul,t + χ2 (1 − χ1 )}kl,t−1• FONC for Hl,t22(1 − α)σν2 (ρ2z Σl,t−1|t−1 + σz2 )fl,t
W yl,tλ̃t (1 − α)Pt
+ ψl,t 2 2= λ̃t w̃t ,Hl,t{fl,t (ρz Σl,t−1|t−1 + σz2 ) + σν2 }2 Hl,t(8.12)

where w̃t is the real wage: w̃t ≡ wt /Pt .
• FONC for kl,tγ λ̃t = βEt∗ (1 − ∆kt )λ̃t+1

k
Rt+1
,
πt+1

(8.13)

where the return on capital is defined as

yl,t
PtW α
+ ql,t (1 − δ) − a(Ul,t )kl,t−12
2ασν2 (ρ2z Σl,t−1|t−1 + σz2 )fl,tπtk+ ψl,t 2 2
×
,
2
2
2
{fl,t (ρz Σl,t−1|t−1 + σz ) + σν } kl,t−1
ql,t−1Rtk =(8.14)

where
ql,t = µ̃l,t /λ̃t ,(8.15)k= ψl,t /λ̃t .
ψl,t(8.16)

48

• FONC for il,t

2



κ γil,tγil,tγil,tγ λ̃t =γ µ̃l,t 1 −−γ −κ−γ
2 il,t−1
il,t−1il,t−12 
γil,t+1
γil,t+1−γ+ βEt∗ µ̃l,t+1 κ
il,t
il,t


(8.17)

R1
We eliminate l-subscripts to denote cross-sectional means (e.g., yt ≡ 0 yl,t dl).
Firms sell their wholesale goods to monopolistically competitive retailers. Conditions
associated with Calvo sticky prices are
Ptn = λ̃t PtW yt + ξp βEt∗



πt+1
π̄

θp

n
Pt+1

θ −1
πt+1 p
d
Pt+1
π̄
 n

Pt
θp
∗
pt =
θp − 1 Ptd 1−θpπ̄∗ 1−θp
1 = (1 − ξp )(pt )+ ξpπtPtd = λ̃t yt + ξp βEt∗

(8.18)−θỹt = p̃t p yt
p̃t = (1 − ξp )(p̃t )−θp + ξp

(8.19)(8.20)(8.21)(8.22)



π̄
πt

−θp
(8.23)

Conditions associated with Calvo sticky wages are
vt1 = vt2
 w ∗ θw −1
πt+1 wt+1
1
vt+1
∗
π̄wt
 w ∗ θw (1+η)
π w
θw
2
vt2 =
(wt∗ )−θw (1+η) Ht1+η + ξw βEt∗ t+1 ∗t+1
vt+1
θw − 1π̄wt 1−θwπ̄
1 = (1 − ξw )(wt∗ )1−θw + ξw Et∗ w
πt
vt1 = (wt∗ )1−θw λ̃t Ht w̃t + ξw βEt∗

πtw = πt w̃t /w̃t−1

49(8.24)(8.25)(8.26)(8.27)(8.28)

Households’ Euler equation:
γ λ̃t = βEt∗ λ̃t+1 Rt /πt+1(8.29)

Monetary policy rule:
Rt
=
R̄



Rt−1
R̄

ρR 

πtπ̄

φπ  φY 1−ρR
yt
R,t
ȳ

(8.30)

Resource constraint:
ct + it = (1 − gt )yt(8.31)The 30 endogenous variables we solve are:kt , yt , it , ct , Ht , Ut , ft , λ̃t , µ̃t , ψt , Rt , Rtk , qt , ψtk , Et∗ zt+1 , z̃t|t , Σt|t , Gaint ,PtW , Ptn , Ptd , p∗t , πt , ỹt , p̃t , vt1 , vt2 , w̃t , wt∗ , πtw
We have listed 30 conditions above, from (8.2) to (8.31). Of the above 30 endogenous
variables, those that are determined at stage 1 are:Ht , Ut , ft , vt1 , vt2 , w̃t , wt∗ , πtw
We now describe the state 2 equilibrium conditions. To avoid repetitions, we only list
conditions that are different from the state 1 conditions.
(8.3):
yl,t = At {fl,t−1 + νl,t },yl,t+s = At+s {Et∗ zl,t+s fl,t+s−1 + νl,t+s },where s ≥ 1.
(8.4):
1−αfl,t = (Ul,t kl,t )α Hl,t(8.6):
z̃l,t|t = z̃l,t|t−1 + Gainl,t (yl,t /At − z̃l,t|t−1 fl,t−1 )(8.7):

2
fl,t−1
Σl,t|t−1
f −1
Gainl,t = 2
fl,t−1 Σl,t|t−1 + σν2 l,t−1(8.9):
Σl,t|t = (1 − Gainl,t fl,t−1 )Σl,t|t−1
50

(8.10):

1−1
W
At+1 ηa ρz Σl,t|t2 fl,tλ̃t+1 Pt+122σν2 ρ2z (ρ2z Σl,t|t + σz2 )fl,tσν2 ρ2z− 2 2+ ψl,t+1 2 2(ρz Σl,t|t + σz2 ) + σν2 }2fl,t (ρz Σl,t|t + σz2 ) + σν2 {fl,tψl,t =βEt∗(8.11):Et∗
2
2ασν2 (ρ2z Σl,t|t + σz2 )fl,t
yl,t+1Wλ̃t+1 Pt+1 α+ ψl,t+1 2 2
Ul,t{fl,t (ρz Σl,t|t + σz2 ) + σν2 }2 Ul,t

=Et∗ λ̃t+1 {χ1 χ2 Ul,t + χ2 (1 − χ1 )}kl,t(8.12):Et∗
2 2(1 − α)σν2 (ρ2z Σl,t|t + σz2 )fl,t
W yl,t+1
λ̃t+1 (1 − α)Pt+1+ ψl,t+1 2 2= Et∗ λ̃t+1 w̃t
Hl,t{fl,t (ρz Σl,t|t + σz2 ) + σν2 }2 Hl,t(8.14):
yl,t+ ql,t (1 − δ) − a(Ul,t−1 )PtW αkl,t−12
2ασν2 (ρ2z Σl,t−1|t−1 + σz2 )fl,t−1πtk+ ψl,t 2
×2
2
2
2{fl,t−1 (ρz Σl,t−1|t−1 + σz ) + σν } kl,t−1
ql,t−1Rtk =(8.25):
vt1 = (wt∗ )1−θw Et∗ λ̃t+1 Ht w̃t + ξw βEt∗

 w ∗ θw −1
πt+1 wt+1
1
vt+1
π̄wt∗

(8.28):
πtw = Et∗ πt+1 w̃t /w̃t−1

8.3

Solution procedure

Here we describe the general solution procedure of the model. The procedure follows themethod used in the example in Section 4.2. First, we derive the law of motion assuming thatthe model is a rational expectations model where the worst case expectations are on averagecorrect. Second, we take the equilibrium law of motion formed under ambiguity and thenevaluate the dynamics under the econometrician’s data generating process. We provide a51

step-by-step description of the procedure:
1. Find the worst-case steady state.
We first compute the steady state of the filtering problem (3.6), (3.7), (3.8), and (3.10),
under the worst-case mean (3.12) to find the firm-level TFP at the worst-case steadystate, z̄ 0 . We then solve the steady state for other equilibrium conditions evaluated atz̄ 0 .
2. Log-linearize the model around the worst-case steady state.
We can solve for the dynamics using standard tools for linear rational expectation
models. We base our discussion based on the method proposed by Sims (2002).
We first need to deal with the issue that idiosyncratic shocks realize at the beginningof stage 2. Handling this issue correctly is important, since variables chosen at stage 1,
such as input choice, should be based on the worst-case TFP, while variables chosen atstage 2, such as consumption and investment, would be based on the realized TFP (butalso on the worst-case future TFP). To do this, we exploit the certainty equivalence
property of linear decision rules. We first solve for decision rules as if both aggregate
and idiosyncratic shocks realize at the beginning of the period. We call them “preproduction decision rules”. We then solve for decision rules as if (i) both aggregate
and idiosyncratic shocks realize at the beginning of the period and (ii) stage 1 variables
are pre-determined. We call them “post-production decision rules”. Finally, when we
characterize the dynamics from the perspective of the econometrician, we combine thepre-production and post-production decision rules and obtain and equilibrium law of
motion.
To obtain pre-production decision rules, we collect the linearized equilibrium conditions, which include firm-level conditions, into the canonical form:
pre,0
pre,0
pre
= Γpreωt + Υpre ηtpre ,
Γpre
0 ŷt
1 ŷt−1 + Ψ

where ŷtpre,0 is a column vector of size k that contains all variables and the conditional
expectations. ŷtpre,0 = ytpre − ȳ0 denotes deviations from the worst-case steady state∗and ηt are expectation errors, which we define as ηtpre = ŷtpre,0 − Et−1ŷtpre,0 such that∗Et−1ηtpre = 0. We define ωt = [el,t et ]0 , where el,t = [z,l,t ul,t νl,t ]0 is a vector of
idiosyncratic shocks and et is a vector of aggregate shocks of size n. For example, forthe baseline model introduced in Section 3, et is a 2 × 1 vector of aggregate TFP andgovernment spending shocks.

52

The vector ŷtpre,0 contains firm-level variables such as firm l’s labor input, Hl,t . In
contrast to other linear heterogeneous-agent models with imperfect information suchas Lorenzoni (2009), all agents share the same information set. Thus, to derive theaggregate law of motion, we simply aggregate over firm l’s linearized conditions andreplace firm-specific variables with their cross-sectional means (e.g., we replace Hl,t with
R1
Ht ≡ 0 Hl,t dl) and set el,t = 0, which uses the law of large numbers for idiosyncratic
shocks.
We order variables in ŷtpre,0 as pre,0 ŷ1,t pre,0 pre,0ŷt= ŷ2,t  ,ŝpre,0
t
pre,0
pre,0
where ŷ1,tis a column vector of size k1 of variables determined at stage 1, ŷ2,t
is a
pre,0
pre,0
pre,0 0column vector of size k2 of variables determined at stage 2, and ŝt= [ŝ1,tŝ2,t ] ,∗zt and s2,t = z̄ − z̃t|t .
where s1,t = z̄ − Et−1

The resulting solution of pre-production decision rules is obtained applying the method
developed by Sims (2002):
pre,0ŷtpre,0 = Tpre ŷt−1+ Rpre [03×1

et ]0 ,

(8.32)

where Tpre and Rpre are k × k and k × (n + 3) matrices, respectively.
The solution of post-production decision rules can be obtained in a similar way by firstcollecting the equilibrium conditions into the canonical form
post,0post,0post
Γpost= Γpostωt + Υpost ηtpost ,0 ŷt
1 ŷt−1 + Ψ

and is given by
post,0ŷtpost,0 = Tpost ŷt−1+ Rpost [03×1

et ]0 ,

where
 post,0 ŷ1,t post,0 
post,0ŷt= ŷ2,t  ,ŝpost,0t
and Tpost and Rpost are k × k and k × (n + 3) matrices, respectively.
3. Characterize the dynamics from the econometrician’s perspective.

53(8.33)

The above law of motion was based on the worst-case probabilities. We need to derive
the equilibrium dynamics under the true DGP, where the cross-sectional mean of firmlevel TFP is z̄. We are interested in two objects: the zero-risk steady state and the
dynamics around that zero-risk steady state.
(a) Find the zero-risk steady state.
This the fixed point ȳ where the decision rules (8.32) and (8.33) are evaluated at
the realized cross-sectional mean of firm-level TFP z̄:ȳpre − ȳ0 = Tpre (ȳ − ȳ0 ),ȳpost − ȳ0 = Tpost (ȳ − ȳ0 ) + Rpost [s̄ 0(n+1)×1 ]0 ,(8.34)where
ȳ1preȳ = ȳ2post  .
s̄postNote that we do not feed in the realized firm-level TFP to the pre-production
decision rules since idiosyncratic shocks realize at the beginning of stage 2.
We obtain s̄ froms̄ = [Tpost
3,1

Tpost
3,2

0
0
Tpost
3,3 ](ȳ − ȳ ) + s̄ ,

post
post
post
where Tpost,
3,1 , T3,2 , and T3,3 are 2 × k1 , 2 × k2 , and 2 × 2 submatrices of T
respectively: postT1,1 Tpost
Tpost
1,2
1,3


Tpost = Tpost
Tpost
Tpost
2,1
2,2
2,3  ,

Tpost
3,1

Tpost
3,2

Tpost
3,3

post
post
post
post
post
where Tpost
1,1 , T1,2 , T1,3 , T2,1 , T2,2 , and T2,3 are k1 × k1 , k1 × k2 , k1 × 2, k2 × k1 ,k2 × k2 , and k2 × 2 matrices, respectively.

(b) Dynamics around the zero-risk steady state.
Denoting ŷt ≡ yt − ȳ the deviations from the zero-risk steady state, we combine
the decision rules (8.32) and (8.33) evaluated at the true DGP and the equations

54

for the zero-risk steady state (8.34) to characterize the equilibrium law of motion:ŷtpre = Tpre ŷt−1 + Rpre [03×1preŷtpost = Tpost [ŷ1,tˆs̃t = [Tpost
3,1ŷ2,t−1

Tpost
3,2

et ]0 ,

(8.35)ŝt−1 ]0 + Rpost [ˆs̃t

pre
Tpost
3,3 ][ŷ1,t0 et ]0 ,ŝt−1 ]0 + Rpost
3,3 [03×1

ŷ2,t−1(8.36)
e t ]0 ,(8.37)

and

pre
ŷ1,t
 post ŷt = ŷ2,t
.
post
ŝt


(8.38)

post
Rpost
:
3,3 is a 2 × n submatrix of R postR1,1
 postpost
R= R2,1
Rpost
3,1

Rpost
1,2
post
R2,2
Rpost
3,2


Rpost
1,3

Rpost
2,3  ,
Rpost
3,3

post
post
post
post
post
post
post
where Rpost
1,1 , R1,2 , R1,3 , R2,1 , R2,2 , R2,3 , R3,1 , and R3,2 are k1 × 2, k1 × 1,
k1 × n, k2 × 2, k2 × 1, k2 × n, 2 × 2, and 2 × 1 matrices, respectively.

We combine equations (8.35), (8.36), (8.37), and (8.38) to obtain the equilibrium
law of motion. To do so, we first define submatrices of Tpre and Rpre : pre T1
 pre preT = T2  ,
Tpre
3
pre
pre
where Tpre
are k1 × k, k2 × k, and 2 × k matrices, respectively,
1 , T2 , and T3
and

 pre
R1,1 Rpre
1,2
Rpre = Rpre
Rpre
2,1
2,2  ,

Rpre
3,1

Rpre
3,2

pre
pre
pre
pre
pre
where Rpre
1,1 , R1,2 , R2,1 , R2,2 , R3,1 , and R3,2 are k1 × 3, k1 × n, k2 × 3, k2 × n,
2 × 3, and 2 × n matrices, respectively.

We then define matrices T and R. A k × k matrix T is given by pre T1
T =  T2  ,T355

where T2 and T3 are k2 × k2 and 2 × 2 matrices, respectively, given by
T2 = [Q2,1

post post
Q2,2 + Tpost
2,2 + R2,1 T3,2

post post
Q2,3 + Tpost
2,3 + R2,1 T3,3 ],T3 = [Q3,1

post post
Q3,2 + Tpost
3,2 + R3,1 T3,2

post post
Q3,3 + Tpost
3,3 + R3,1 T3,3 ],and Q2,1 , Q2,2 , and Q2,3 are k2 × k1 , k2 × k2 , and k2 × 2 submatrices of Q2 ,post postprewhere Q2 ≡ (Tpost
Q2,2 Q2,3 ]. Similarly,
2,1 + R2,1 T3,1 )T1 , so that Q2 = [Q2,1
Q3,1 , Q3,2 , and Q3,3 are k3 × k1 , k3 × k2 , and k3 × 2 submatrices of Q3 , whereprepost post
Q3,2 Q3,3 ].
Q3 ≡ (Tpost
3,1 + R3,1 T3,1 )T1 , so that Q3 = [Q3,1
A k × n matrix R is given by pre R1,2
R =  R2  ,
R3
where
pre
post
post prepost
post
R2 = Tpost
2,1 R1,2 + R2,1 (T3,1 R1,2 + R3,3 ) + R2,3 ,prepost
post prepost
post
R3 = Tpost
3,1 R1,2 + R3,1 (T3,1 R1,2 + R3,3 ) + R3,3 .

The equilibrium law of motion is then given byŷt = Tŷt−1 + Ret .

8.4

Bayesian estimation: the role of the credit spread

We argue that the inclusion of the spread in the estimation is the key reason why in our model
the financial wedge shock becomes an important driver of the business cycle. To see this,
we first re-estimate our flexible-price and sticky-price models and their RE versions without
using the credit spread in the estimation. The column labeled “No spread used” in Table 10
reports the contributions of the financial wedge shock in explaining the variance of output.
First, consider the flexible-price model (Panel A). In line with the main estimation that uses
the spread, in the RE version the financial wedge shock can only explain a negligible shareof output variance. This is not surprising, since in the main estimation the measurement
error for the spread was quite large. In contrast to the main estimation, however, thecontribution of the financial wedge shock is negligible even with endogenous uncertainty. The
intuition is as follows. In the flexible-price model, the model cannot generate co-movement

56

Table 10: Output variance explained by the financial wedge shock: the role of credit spread
No meas. error
Model
Spread not usedin spread
Panel A: Flexible priceBaseline
0.00
0.13
RE
0.00
0.04
Panel B: Sticky priceBaseline
0.48
0.72
RE
0.15
0.15
Notes: We report the percent of variance of output at the business cycle frequency (6–32 quarters) thatcan be explained by the financial wedge shock. “Spread not used” refers to results from estimations where
the credit spread is not used as an observable. “No meas. error in spread” refers to results fromestimations where the credit spread is observed without a meaurement error.

of consumption and hours in response to the financial wedge shock in the short run (seeFigure 3). The likelihood estimator thus tries to reduce the size of the financial wedge shock
as much as possible.34 This is feasible since the credit spread is not used in the estimation.
Next, consider the sticky-price model (Panel B). As in the flexible-price model, the resultof the RE version is in line with the main estimation. With endogenous uncertainty, thefinancial wedge shock becomes more important but its contribution to output variance issmaller than the main estimation (48 percent vs. 73 percent). In the data, the credit spreadis strongly countercyclical, which pushes the estimation towards assigning a larger role tothe financial wedge shock when the spread is used as an observable.
We also consider what happens when we estimate our models with no measurement error
in the spread (Table 10, “No meas. error in spread”). For both flexible-price and sticky-pricemodels, the results of the baseline models with endogenous uncertainty are very similar to
those from the main estimation. This is because the estimated measurement errors for the
spread for the baseline models are very small in the main estimation to begin with. For the
RE version of the flexible-price model, the financial wedge shock explains a small fraction of
output (4 percent) and it comes at the cost of countercyclical consumption; the correlation
between output growth and consumption growth is -0.19. For the sticky-price RE model, thefinancial wedge shock explains 15 percent of output variance but the estimated real rigidities
are large; the consumption habit is b = 0.92 and the investment adjustment cost is κ = 2.42.35
The large real rigidities lead to macro quantities being too smooth. For example, the model
34

Indeed, the estimated parameters for the financial wedge shock process are ρ∆ = 0.36 and 100σ∆ = 0.04,
compared to ρ∆ = 0.53 and 100σ∆ = 0.10 in the main estimation.
35
The estimated nominal rigidities are similar to those found in the main estimation.

57

substantially understates the standard deviations of output growth and consumption growth(0.50 and 0.23, respectively, in the model versus 0.60 and 0.50, respectively, in the data).
To summarize, we find that in our model the financial wedge shock becomes an importantsource of business cycle when the credit spread, measured with or without error, is used in
the estimation. Intuitively, the financial wedge shock needs to be large since the spread isvolatile and countercyclical. Without endogenous uncertainty, however, this comes at thecost of generating counterfactual predictions for other macro variables.

8.5

Data sources

We use the following data:
1. Real GDP in chained dollars, BEA, NIPA table 1.1.6, line 1.
2. GDP, BEA, NIPA table 1.1.5, line 1.
3. Personal consumption expenditures on nondurables, BEA, NIPA table 1.1.5, line 5.
4. Personal consumption expenditures on services, BEA, NIPA table 1.1.5, line 6.
5. Gross private domestic fixed investment (nonresidential and residential), BEA, NIPA
table 1.1.5, line 8.
6. Personal consumption expenditures on durable goods, BEA, NIPA table 1.1.5, line 4.
7. Nonfarm business hours worked, BLS PRS85006033.
8. Civilian noninstitutional population (16 years and over), BLS LNU00000000.
9. Effective federal funds rate, Board of Governors of the Federal Reserve System.
10. Moody’s Seasoned Baa Corporate Bond Yield Relative to Yield on 10-Year Treasury
Constant Maturity (Baa spread), downloaded from Federal Reserve Economic Data,
Federal Reserve Bank of St. Louis.
We then conduct the following transformations of the above data:
11. Real per capita GDP: (1)/(8)12. GDP deflator: (2)/(1)13. Real per capita consumption: [(3)+(4)]/[(8)×(12)]14. Real per capita investment: [(5)+(6)]/[(8)×(12)]15. Per capita hours: (7)/(8)58