Uncertainty Shocks in a Model of Effective Demand

29 Pages Posted: 2 Oct 2012

See all articles by Susanto Basu

Susanto Basu

Boston College, College of Arts and Sciences, Department of Economics; National Bureau of Economic Research (NBER)

Brent Bundick

Federal Reserve Bank of Kansas City

Multiple version iconThere are 3 versions of this paper

Date Written: September 2012

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.

Suggested Citation

Basu, Susanto and Bundick, Brent, Uncertainty Shocks in a Model of Effective Demand (September 2012). NBER Working Paper No. w18420, Available at SSRN: https://ssrn.com/abstract=2155532

Susanto Basu (Contact Author)

Boston College, College of Arts and Sciences, Department of Economics ( email )

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Chestnut Hill, MA 02467-3806
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National Bureau of Economic Research (NBER) ( email )

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Brent Bundick

Federal Reserve Bank of Kansas City ( email )

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Kansas City, MO 64198
United States

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