Do Uncertainty Shocks Always Matter for Business Cycles?

The answer to the title question is no. Fitting a Markov-switching structural vector autoregression to U.S. data, we show that uncertainty affects real economy differentially depending on the state of financial markets; e.g., an adverse shock that causes a 10 percentage points increase in the VIX index implies a one percent output decline in a regime of financial stress, but effects that are close to zero in tranquil regime. We use this evidence to estimate key parameters of a business cycle model, in which agents are aware of the possibility of regime switches in the transmission mechanism. We show that the differences in dynamics across regimes do not only result from changes in the degree of financial frictions, but also on agents’ expectations around these changes. Pessimistic expectations about future financial conditions amplify contractionary effects of uncertainty shocks on aggregate activity.