Business Cycles and Endogenous Uncertainty

Abstract

Recessions are times of increased uncertainty and volatility at the micro level. This widely documented empirical pattern has been interpreted as the effect of uncertainty shocks, mediated by various frictions, on aggregate economic activity. We explore the hypothesis that the causation runs the opposite way: first moment shocks induce risky behavior, which in turn raises observed cross-sectional dispersion and time series volatility of individual economic outcomes. Specifically, we study the cyclical pattern of the dispersion of price changes, and the resulting changes in sales and employment at the firm-level. We formulate an imperfect information version of the standard model of monopolistic competition. The elasticity of demand differs across products, and firms are not sure about the elasticity of the demand they face, but learn it from their volume of sales. Due to a fixed operation cost, information is valuable to decide whether to exit the market. Idiosyncratic demand shocks impair learning. The model is fully microfounded and can be aggregated to study general equilibrium. Deviations from average prices are costly to the firm in terms of forgone profits, but the response of sale volumes is informative about market power. Bad economic times are the best times to price-experiment, as the opportunity cost of price mistakes is lower and exit looms large. Following a negative aggregate shock to nominal spending, firms at first keep their prices relatively high, in order to learn whether the demand for their product is sufficiently inelastic and resilient to survive, and then change them further by an amount that depends on what they have learned.

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