Working Paper: NBER ID: w18420
Authors: Susanto Basu; Brent Bundick
Abstract: Can increased uncertainty about the future cause a contraction in output and its components? An identified uncertainty shock in the data causes significant declines in output, consumption, investment, and hours worked. Standard general-equilibrium models with flexible prices cannot reproduce this comovement. However, uncertainty shocks can easily generate comovement with countercyclical markups through sticky prices. Monetary policy plays a key role in offsetting the negative impact of uncertainty shocks during normal times. Higher uncertainty has even more negative effects if monetary policy can no longer perform its usual stabilizing function because of the zero lower bound. We calibrate our uncertainty shock process using fluctuations in implied stock market volatility, and show that the model with nominal price rigidity is consistent with empirical evidence from a structural vector autoregression. We argue that increased uncertainty about the future likely played a role in worsening the Great Recession. The economic mechanism we identify applies to a large set of shocks that change expectations of the future without changing current fundamentals.
Keywords: Uncertainty; Macroeconomic Fluctuations; Effective Demand
JEL Codes: E32; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty shock (D89) | Declines in output (E23) |
| Uncertainty shock (D89) | Declines in consumption (D12) |
| Uncertainty shock (D89) | Declines in investment (G31) |
| Uncertainty shock (D89) | Declines in hours worked (J22) |
| Uncertainty shock (D89) | Monetary policy moderating effects (E52) |
| Uncertainty shock (D89) | Worsening of the Great Recession (F65) |