Uncertainty and the Business Cycle

We show that fluctuations in aggregate uncertainty generate state-dependent dynamics in a general equilibrium model with labor-market search frictions and occasionally binding constraints on wage bargaining. The existence of a profit risk-premium for firms implies that an increase in uncertainty has a large impact during recessions but modest effects on average. The profit risk-premium does not depend on nominal rigidities or markup variations. Additionally, we show that output forecast error variance is countercyclical, even if uncertainty shocks are equally likely in expansions and recessions. Thus, our framework can explain the correlation between empirical measures of economic uncertainty and recessions. We obtain our results using a third-order Taylor expansion of the equilibrium equations and approximating a non-convexity in the wage decision rule with a novel implementation of penalty function methods.