Faculty of Business Seminar Series/ Sumru G. Altuğ

Title: Ambiguous Business Cycles: A Quantitative Assessment

Abstract: What role does ambiguity aversion play in generating cyclical fluctuations and asset price movements? In this paper, we examine the cyclical dynamics of a business cycle model with ambiguity averse consumers and investment irreversibility using the smooth ambiguity model of Klibanoff et al. (2005, 2009). The model differentiates between the sources of ambiguity and ambiguity aversion, and allows for learning about an unobserved cyclical component of TFP. We establish two

key results. First, we show 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. Nevertheless, we show that ambiguity and ambiguity aversion affect endogenous choices through information and learning effects. Based on Bayesian estimates of the underlying TFP process, we show that more precise beliefs regarding the unknown process enerating the TFP process are associated with lower cyclical variability and greater persistence in the quantity variables. By examining the behavior of the risk-free rate, we also show that information and learning effects are the channels through which uncertainty/ambiguity aversion affect the behavior of asset prices. In this case, the greater the distortions induced by ambiguity and ambiguity aversion, the lower is the risk-free rate.

Place: Meeting Room AB2-345