When It Rains It Pours: Cascading Uncertainty Shocks

Abstract

We empirically document that serial uncertainty shocks are (1) common in the data and (2) have an increasingly stronger impact on the macroeconomy. In other words, a series of bad (positive) uncertainty shocks exacerbates the economic decline significantly. From a theoretical perspective, these findings are puzzling: existing benchmark general equilibrium models do not deliver the observed amplification. We show analytically that a state dependent precautionary motive with respect to uncertainty shocks is required. Our derivations suggest that the state dependent precautionary motive only binds at fourth order approximations or higher. Fundamentally, in DSGE models solved with perturbations, agents have always possessed a state dependent precautionary motive but typical solution methods were hiding this fact. Future studies should consider solving the model via fourth (or higher) order perturbation in order to avoid understating the effect of uncertainty shocks that occur in succession.

Keywords: Dynamic Equilibrium Economies; Stochastic Volatility; Perturbation.

JEL Classification: C63, C68, E37