Ambiguity and the business cycle: A quantitative assessment

This paper examines the cyclical dynamics of a business cycle model with ambiguity-averse consumers and investment irreversibility using the smooth ambiguity model of Klinaboff et al (2005,2009). It seeks to determine if a calibrated/empirically founded productivity shock process that allows for asymmetric effects in booms versus recessions can generate the cyclical dynamics of real variables (such as consumption, investment and output) of the strength and duration observed in the data when coupled with ambiguity and investment irreversibility. The paper uses data from the Federal Reserve of San Francisco on aggregate US total factor productivity, aggregate gross domestic product, consumption, investment, and hours worked to fit a Real Business Cycle model with ambiguity aversion in preferences and investment irreversibility.

Our results reveal some interesting findings regarding the role of ambiguity aversion with learning in an otherwise standard real business cycle model. As Tallarini (2000) or Backus et al. (2014) have emphasized in their analysis of cyclical fluctuations generated by recursive non-expected utility or ambiguity-averse preferences, fluctuations in aggregate quantities arise primarily from changes in intertemporal substitution motives while ambiguity aversion plays a smaller role. Our findings corroborate this result. Specifically, we find that the intertemporal substitution in consumption and leisure operating through the transmission channels of the standard real business cycle model dominates the impact of uncertainty aversion when agents can choose to optimally smooth consumption through investment and hours worked choices in response to labor-augmenting technology shocks. However, ambiguity and ambiguity aversion affect endogenous choices through information and learning effects. This is a transmission channel that is typically missing in business cycle models, and implies that there is a trade-off between greater volatility and information, that is, in environments with uncertainty about the exogenous process-determining fundamentals, their endogenous choices will tend to display greater variability in response to ambiguous shocks.