Uncertainty Shocks in a Model of Effective Demand

Susanto Basu and Brent Bundick

No 18420, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E32 E52 (search for similar items in EconPapers)
Date: 2012-09
New Economics Papers: this item is included in nep-bec, nep-dge, nep-mac and nep-mon
Note: EFG ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (184)

Published as Susanto Basu & Brent Bundick, 2017. "Uncertainty Shocks in a Model of Effective Demand," Econometrica, Econometric Society, vol. 85, pages 937-958, May.

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Related works:
Working Paper: Uncertainty Shocks in a Model of Effective Demand (2015)
Working Paper: Uncertainty shocks in a model of effective demand (2014)
Working Paper: Uncertainty shocks in a model of effective demand (2012)
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