Learning, confidence, and business cycles

Abstract

We argue that information accumulation provides a quantitatively successful propagation mechanism that challenges and empirically improves on the conventional New Keynesian models with many nominal and real rigidities. In particular, we build a tractable heterogeneous-firm business cycle model where firms face Knightian uncertainty about their profitability and learn it through production. The feedback between uncertainty and economic activity maps fundamental shocks into an as if procyclical equilibrium confidence process, generating co-movement driven by demand shocks, amplified and hump-shaped dynamics, countercyclical correlated wedges in the equilibrium conditions for labor, risk-free and risky assets, and countercyclical firm-level and aggregate dispersion of forecasts.