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Uncertainty shocks in a model of effective demand

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  • Susanto Basu
  • Brent Bundick

Abstract

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 macro 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. Calibrating the size of uncertainty shocks using fluctuations in the VIX, the authors 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.

Suggested Citation

  • Susanto Basu & Brent Bundick, 2012. "Uncertainty shocks in a model of effective demand," Working Papers 12-15, Federal Reserve Bank of Boston.
    • Handle: RePEc:fip:fedbwp:12-15
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    More about this item

    Keywords

    Monetary policy ; Uncertainty ; Business cycles;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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