Understanding Uncertainty Shocks and the Role of Black Swans

43 Pages Posted: 5 May 2023

See all articles by Laura Veldkamp

Laura Veldkamp

Columbia University - Columbia Business School; National Bureau of Economic Research (NBER)

Anna Orlik

Board of Governors of the Federal Reserve System

Date Written: December, 2022

Abstract

Economic uncertainty is a powerful force in the modern economy. Research shows that surges in uncertainty can trigger business cycles, bank runs and asset price fluctuations. But where do sudden surges in uncertainty come from? This paper provides a data-disciplined theory of belief formation that explains large fluctuations in uncertainty. It argues that people do not know the true distribution of macroeconomic outcomes. Like Bayesian econometricians, they estimate a distribution. Our main contribution is to explain why real-time estimation of distributions with non-normal tails results in large uncertainty fluctuations. We use theory and data to show how small changes in estimated skewness whip around probabilities of unobserved tail events (black swans). Our estimates, based on real-time GDP data, reveal that revisions in the estimates of black swan risk explain most of the fluctuations in uncertainty.

Keywords: forecast bias, rational expectations, model uncertainty, expectations formation, bayesian econometrics

JEL Classification: D80, D84, C11

Suggested Citation

Veldkamp, Laura and Orlik, Anna, Understanding Uncertainty Shocks and the Role of Black Swans (December, 2022). FEDS Working Paper No. 2022-83, Available at SSRN: https://ssrn.com/abstract=4438756 or http://dx.doi.org/10.17016/FEDS.2022.083

Laura Veldkamp

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Anna Orlik (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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