Uncertainty Shocks in a Model of Effective Demand

29 Pages Posted: 28 Nov 2014 Last revised: 29 Mar 2017

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: November 1, 2016

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 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

Basu, Susanto and Bundick, Brent, Uncertainty Shocks in a Model of Effective Demand (November 1, 2016). Federal Reserve Bank of Kansas City Working Paper No. 14-15, Available at SSRN: https://ssrn.com/abstract=2531066 or http://dx.doi.org/10.2139/ssrn.2531066

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

Federal Reserve Bank of Kansas City ( email )

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Kansas City, MO 64198
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