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Uncertainty and economic activity: a multi-country perspective

Author

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  • Cesa-Bianchi, Ambrogio

    () (Bank of England)

  • Pesaran, M Hashem

    () (Department of Economics)

  • Rebucci, Alessandro

    () (Johns Hopkins University)

Abstract

Measures of economic uncertainty are countercyclical, but economic theory does not provide definite guidance on the direction of causation between uncertainty and the business cycle. This paper takes a common-factor approach to the analysis of the interaction between uncertainty and economic activity in a multi-country model without a priori restricting the direction of causality at the level of individual countries. Motivated by the observation that cross-country correlations of volatility series are much higher than cross-country correlations of GDP growth series, we set up a multi-country version of the Lucas tree model with time-varying volatility consistent with this stylized fact and use it to identify two common factors, a real and a financial one. We then quantify the absolute and the relative importance of the common shocks as well as country-specific volatility and GDP growth shocks. The paper highlights three main empirical findings. First, it is shown that most of the unconditional correlation between volatility and growth can be accounted for by shocks to the real common factor, which is extracted from world growth in our empirical model and linked to the risk-free rate in the theoretical model and in the data. Second, the share of volatility forecast error variance explained by the real common shock and by country-specific growth shocks amounts to less than 5%. Third, common financial shocks explain about 10% of the growth forecast error variance, but when such shocks occur, their negative impact on growth is large and persistent. In contrast, country-specific volatility shocks account for less than 1%-2% of the forecast error variance decomposition of country-specific growth rates.

Suggested Citation

  • Cesa-Bianchi, Ambrogio & Pesaran, M Hashem & Rebucci, Alessandro, 2018. "Uncertainty and economic activity: a multi-country perspective," Bank of England working papers 730, Bank of England.
  • Handle: RePEc:boe:boeewp:0730
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Chudik, A. & Pesaran, H. & Mohaddes, K., 2018. "Identifying Global and National Output and Fiscal Policy Shocks Using a GVAR," Cambridge Working Papers in Economics 1874, Faculty of Economics, University of Cambridge.
    2. Seohyun Lee & Rickard Nyman, 2019. "Tracking Uncertainty through the Relative Sentiment Shift Series," Working Papers 2019-12, Economic Research Institute, Bank of Korea.
    3. George Kapetanios & M. Hashem Pesaran & Simon Reese, 2018. "A Residual-based Threshold Method for Detection of Units that are Too Big to Fail in Large Factor Models," CESifo Working Paper Series 7401, CESifo Group Munich.

    More about this item

    Keywords

    Uncertainty; business cycle; common factors; real and financial global shocks; multi-country; identification; realized volatility;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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