Uncertainty Shocks in a Model of Effective Demand

30 Pages Posted: 26 Jun 2013

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

Boston College - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: September 8, 2011

Abstract

This paper examines the role of uncertainty shocks in a one-sector, representative-agent dynamic stochastic general equilibrium model. When prices are flexible, uncertainty shocks are not capable of producing business cycle co-movements among key macro variables. With countercyclical markups through sticky prices, however, uncertainty shocks can generate fluctuations that are consistent with business cycles. Monetary policy usually plays a key role in offsetting the negative impact of uncertainty shocks. If the central bank is constrained by the zero lower bound, then monetary policy can no longer perform its usual stabilizing function and higher uncertainty has even more negative effects on the economy. Calibrating the size of uncertainty shocks using fluctuations in the VIX, the authors find that increased uncertainty about the future may indeed have played a significant role in worsening the Great Recession, which is consistent with statements by policymakers, economists, and the financial press.

Keywords: uncertainty shocks, monetary policy, sticky-price models

JEL Classification: E32, E52

Suggested Citation

Basu, Susanto and Bundick, Brent, Uncertainty Shocks in a Model of Effective Demand (September 8, 2011). FRB of Boston Working Paper No. 12-15, Available at SSRN: https://ssrn.com/abstract=2285020 or http://dx.doi.org/10.2139/ssrn.2285020

Susanto Basu (Contact Author)

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

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National Bureau of Economic Research (NBER) ( email )

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Brent Bundick

Boston College - Department of Economics ( email )

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HOME PAGE: http://www2.bc.edu/brent-bundick/

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