Uncertainty Shocks in a Model of Effective Demand
29 Pages Posted: 28 Nov 2014 Last revised: 29 Mar 2017
Date Written: November 1, 2016
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 nor-mal 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: Uncertaity Shocks, Monetary Policy, Sticky-Price Models, Epstein-Zin Preferences, Zero Lower Bound on Nominal Interest Rates
JEL Classification: E32, E52
Suggested Citation: Suggested Citation