When It Rains It Pours: Cascading Uncertainty Shocks

Abstract

Uncertainty shocks can be self-reinforcing. 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. We then generate the cascading effect of uncertainty shocks in a standard DSGE model. Related to this finding is the non-linear scaling effect of larger positive uncertainty shocks. As the size of the positive shock doubles, the macroeconomic response more than doubles. Standard theoretical models solved under third order perturbation cannot generate these empirical results: a fourth order perturbation solution is crucial.

Keywords: Dynamic Equilibrium Economies; Stochastic Volatility; Asymmetric Impulse Responses; Perturbation

JEL Classification: C63, C68, E37