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Uncertainty shocks in a model of effective demand

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  • Susanto Basu
  • Brent Bundick

Abstract

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.

Suggested Citation

  • Susanto Basu & Brent Bundick, 2014. "Uncertainty shocks in a model of effective demand," Research Working Paper RWP 14-15, Federal Reserve Bank of Kansas City.
  • Handle: RePEc:fip:fedkrw:rwp14-15
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    More about this item

    Keywords

    Uncertainty Shocks; Monetary Policy; Sticky-Price Models; Zero Lower Bound on Nominal Interest Rates;
    All these keywords.

    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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