Ambiguity and Financial Uncertainty in a Real Business Cycle Model

Abstract

We examine a representative-agent production economy with stochastic mean and volatility of productivity growth, in which the agent has ambiguity aversion and learns about the mean growth state. In recessions, the agent's heightened concern about state uncertainty increases financial uncertainty, measured by the risk-neutral variance of market returns. Consistent with empirical observations, financial uncertainty relates negatively to quantities but positively to volatilities of quantities. Financial uncertainty also leads to lower equity value and carries a positive risk premium. Our calibrated model can closely match moments of quantities and asset returns and also generate a sizable variance risk premium.