Uncertainty Shocks in a Model of Effective Demand

By Susanto Basu and Brent Bundick

http://d.repec.org/n?u=RePEc:boc:bocoec:774&r=dge

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, we 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.

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Another paper that studies the current uncertain environment, with a disheartening result that the Fed can currently do nothing about it. It would be interesting to see in which way this result also applies to an environment where there is policy uncertainty.

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