Ambiguity Aversion and Heterogeneity in Households’ Beliefs

Abstract

UK households that wish for lower inflation and lower nominal interest rates have higher expected inflation. We interpret the evidence through the lens of a New Keynesian model where ambiguity-averse households differ in wealth, skill, labor market participation, and the receipt of government transfers and are subject to Knightian uncertainty. Households act based on beliefs that are negatively affected by their wishes, the more so the greater the amount of uncertainty. Using indirect inference, we find substantial output costs due to uncertainty. Monetary policy uncertainty contributes little to the costs because households generally dislike monetary expansions. (JEL D12, D81, D83, E12, E31, E43, E52)