Working Paper: CEPR ID: DP14715
Authors: Federico Ravenna; Matteo Cacciatore
Abstract: We show that occasional deviations from efficient wage setting generate strong and state-dependent amplification of uncertainty shocks and can explain the cyclical behavior of empirical measures of uncertainty. Central to our analysis is the existence of matching frictions in the labor market and an occasionally binding constraint on downward wage adjustment. The wage constraint enhances the concavity of firms' hiring rule, generating an endogenous profit-risk premium. In turn, uncertainty shocks increase the profit-risk premium when the economy operates close to the wage constraint. This implies that higher uncertainty can severely deepen a recession, although its impact is weaker on average. Additionally, the variance of the unforecastable component of future economic outcomes always increases at times of low economic activity. Thus, measured uncertainty rises in a recession even in the absence of uncertainty shocks.
Keywords: uncertainty; business cycle; unemployment; occasionally binding constraints
JEL Codes: E32; E2; E6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| aggregate uncertainty (E10) | countercyclicality (E32) |
| first-moment shocks (C69) | variance of unforecastable component of future economic outcomes (D89) |
| downward wage rigidity (J31) | amplification of uncertainty shocks (D89) |
| binding wage constraint (J31) | concavity of firms' hiring rules (D22) |
| concavity of firms' hiring rules (D22) | job creation and employment dynamics (J68) |
| uncertainty shocks (D89) | output decline (E23) |
| uncertainty (D89) | output loss during recessions (E20) |