Firm Heterogeneity, Financial Frictions and Ambiguity

This paper studies the effects of ambiguity (Knightian uncertainty) on business cycles and inequality in an economy with heterogeneous agents. Ambiguity-averse entrepreneurs operate in a model with financial frictions and a market-wide source of ambiguous information. Entrepreneurs use a worst-case criterion to formulate expectation on the total factor productivity and are heterogeneous in terms of assets and productivity. Comparing our economy with one with the same fundamentals but with no uncertainty, we find that ambiguity (i) increases the productivity threshold to access the market, (ii) does not alter the relative consumption gap between active and inactive entrepreneurs and (iii) increases the consumption gap between entrepreneurs and workers. We also find that, in the long-run, an economy featuring ambiguity accumulates more assets and produces more. This is the consequence of the entrepreneurs’ hedging strategy and the wage suppression caused by ambiguity