Uncertainty Shocks in a Model of Effective Demand

Susanto Basu and Brent Bundick

No 774, Boston College Working Papers in Economics from Boston College Department of Economics

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.

Keywords: Uncertainty Shocks; Monetary Policy; Sticky-Price Models; Zero Lower Bound on Nominal Interest Rates (search for similar items in EconPapers)
JEL-codes: E32 E52 (search for similar items in EconPapers)
Date: 2011-09-08, Revised 2015-11-01
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (112)

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Related works:
Journal Article: Uncertainty Shocks in a Model of Effective Demand (2017)
Working Paper: Uncertainty shocks in a model of effective demand (2014)
Working Paper: Uncertainty shocks in a model of effective demand (2012)
Working Paper: Uncertainty Shocks in a Model of Effective Demand (2012)
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