Business cycles and endogenous uncertainty

Recessions are times of increased uncertainty and volatility at the micro level. This widely documented empirical pattern has been interpreted as the e¤ect of uncertainty shocks, mediated by various frictions, on aggregate economic activity. We explore the hypothesis that the causation runs the opposite way: \u85 rst moment shocks induce risky behavior, which in turn raises observed cross-sectional dispersion and time series volatil-ity of individual economic outcomes. Speci\u85cally, we study the cyclical pattern of the dispersion of price changes, and the resulting changes in sales and employment at the rm-level. We formulate an imperfect information version of the standard monopolisti-cally competitive model. The elasticity of demand di¤ers across products, and \u85rms are not sure about the elasticity of the demand they face, but learn it from their volume of sales. Due to a \u85xed 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 \u85rm in terms of forgone pro\u85ts, but the response of sale volumes is informa-tive 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, \u85 rms at \u85rst keep their prices relatively high, in order to learn whether the demand for their product is su ¢ ciently inelastic and resilient to survive, and then change them further by an amount that depends on what they have learned. We thank Veronica Guerrieri for a very helpful discussion and Eduardo Engel, Mikhail Golosov, and Joseph Vavra for comments. The usual disclaimer applies. 1