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Uncertainty Shocks in a Model of Effective Demand

  • Susanto Basu

    (Boston College
    NBER)

  • Brent Bundick

    ()

    (Boston College)

Can increased uncertainty about the future cause a contraction in output and its components? This paper examines the role of uncertainty shocks in a one-sector, representative-agent dynamic stochastic general-equilibrium model. When prices are flexible, uncertainty shocks are not capable of producing business-cycle comovements among key macroeconomic variables. With countercyclical markups through sticky prices, however, uncertainty shocks can generate fluctuations that are consistent with business cycles. Monetary policy usually plays a key role in offsetting the negative impact of uncertainty shocks. If the central bank is constrained by the zero lower bound, then monetary policy can no longer perform its usual stabilizing function and higher uncertainty has even more negative effects on the economy. We calibrate the size of uncertainty shocks using fluctuations in the VIX and find that increased uncertainty about the future may indeed have played a significant role in worsening the Great Recession, which is consistent with statements by policymakers, economists, and the financial press.

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Paper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 774.

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Date of creation: 08 Sep 2011
Date of revision: 20 Sep 2012
Handle: RePEc:boc:bocoec:774
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