The Uncertainty Multiplier and Business Cycles
I study a business cycle model where agents learn about the state of the economy by accumulating capital. During recessions, agents invest less, and this generates noisier estimates of macroeconomic conditions and an increase in uncertainty. The endogenous increase in aggregate uncertainty further reduces economic activity, which in turn leads to more uncertainty, and so on. Thus, through changes in uncertainty, learning gives rise to a multiplier effect that amplifies business cycles. I use the calibrated model to measure the size of this uncertainty multiplier.
What drives business cycles? A rapidly growing literature argues that shocks to uncertainty are a significant source of business cycle dynamics—see, for example, Bloom (2009), Fern´andezVillaverde et al. (2011), Gourio (2012), and Christiano et al. (forthcoming). However, the literature faces at least two important criticisms. In uncertainty shock theories, recessions are caused by exogenous increases in the volatility of structural shocks. First, fluctuations in uncertainty may be, at least partially, endogenous. The distinction is crucial because if uncertainty is an equilibrium object that is coming from agents’ actions, policy experiments that treat uncertainty as exogenous are subject to the Lucas critique. Second, some authors (Bachmann and Bayer 2013, Born and Pfeifer 2012, and Chugh 2012) have argued that, given small and transient fluctuations in observed ex-post volatility, changes in uncertainty have negligible effects. However, time-varying volatility need not be the only source of time-varying uncertainty. If this is the case, these papers may be understating the contribution of changes in uncertainty to aggregate fluctuations.