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Uncertainty Shocks in a Model of Effective Demand

  • Susanto Basu

    (Boston College

  • Brent Bundick


    (Federal Reserve Bank of Kansas City)

Can increased uncertainty about the future cause a contraction in output and its components? An identified uncertainty shock in the data causes significant declines in output, consumption, investment, and hours worked. Standard general-equilibrium models with flexible prices cannot reproduce this comovement. However, uncertainty shocks can easily generate comovement with countercyclical markups through sticky prices. Monetary policy plays a key role in offsetting the negative impact of uncertainty shocks during normal times. Higher uncertainty has even more negative effects if monetary policy can no longer perform its usual stabilizing function because of the zero lower bound. We calibrate our uncertainty shock process using fluctuations in implied stock market volatility and show that the model with nominal price rigidity is consistent with empirical evidence from a structural vector autoregression. We argue that increased uncertainty about the future likely played a role in worsening the Great Recession.

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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: 01 Nov 2015
Handle: RePEc:boc:bocoec:774
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