Uncertainty shocks in a model with mean-variance frontiers and endogenous technology choices

This paper builds a model to show how increases in aggregate uncertainty – an uncertainty shock – can generate recessions. Uncertainty shocks in the model are able to both account for a significant portion of business cycle fluctuations observed in data and generate positive comovements between output, consumption, investment, and hours. The key assumption of the model is that firm managers endogenously choose what projects to undertake and that the menu of these projects lies on a positively sloped mean-variance frontier – high-return projects are also high-risk projects. In times of high aggregate uncertainty, managers choose to undertake low-risk projects, and thus low-return projects, which in turn leads to a recession. Moreover, the model also matches various stylized facts about time series and cross-sectional variations in TFP and suggests shortcomings in using TFP data to calculate exogenous TFP shocks.