Really Uncertain Business Cycles

By Nicholas Bloom, Max Floetotto, Nir Jaimovich, Itay Saporta-Eksten and Stephen J. Terry

We propose uncertainty shocks as a new shock that drives business cycles. First, we demonstrate that microeconomic uncertainty is robustly countercyclical, rising sharply during recessions, particularly during the Great Recession of 2007-2009. Second, we quantify the impact of time-varying uncertainty on the economy in a dynamic stochastic general equilibrium model with heterogeneous firms. We find that reasonably calibrated uncertainty shocks can explain drops and rebounds in GDP of around 3%. Moreover, we show that increased uncertainty alters the relative impact of government policies, making them initially less effective and then subsequently more effective.

I am not sure I would qualify uncertainty shocks as new shocks. I have mentioned before the paper by Basu and Bundick that also features time varying variance for TFP shocks (plus similar shocks to intertemporal substitution). This paper is still a significant step forward as it uses plant level data to calibrate the shock process and does not need price rigidity to obtain significant results. It is particularly interesting to see how policy response effectiveness changes through time.

See also a previous post on policy uncertainty.

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3 Responses to Really Uncertain Business Cycles

  1. M. H. says:

    So, is now every recession going to be explained by a different shock? That is not going to help in explaining future recessions and policy. What became of Lucas’ agenda to find a simple and unique model?

  2. Nick Bloom says:

    Christian – Many thanks for posting this and great idea, and we’ll try to respond to the all posts. The reason we called this a “new” shock is this paper started circulating as a mimeo 2007 (for example the reference in ), so at the time it was new. Your are right many papers have come out since then that take very different approaches for uncertainty, but as is standard in academia (like patents as well in fact) we date this by time of innovation rather than publication. Basu and Bundick is a lovely piece that does this in GE with New-Keynesian sticky prices with a representative firm, driven by demand short-falls. I see as a complementary mechanism to our real-options effects and their work is in fact very relevant to the recent recession where demand shortfalls induced by high-uncertainty have I believe been a major factor.

    Mr H – Thanks for the comment – uncertainty rises in every recession – for example as shown in Figure 3. But as you say this was not pushed as an explanation previously (at least that much prior to the late 2000s) for three reasons. First, the micro-data to examine uncertainty was not easily available. Second, models like the RBC model assume certainly equivalence so that uncertainty was assumed not to matter. Finally, the recent recession seems to have generated massive uncertainty so research has focused on this much more now.

    In terms of magnitudes our work suggests uncertainty accounts for maybe 1/3 of business cyclical fluctuations – both as an amplification and a propagation mechanism. I think the big challenge in this literature now is identifying causation – does uncertainty cause recessions, recessions cause uncertainty, or both occur together?

  3. Alessandro Rebucci says:

    I tend to agree with Christian. News shocks essentially provide more, new information to agents. As such they tend to reduce aggregate volatility rather than increasing it. This is one of the results in a well known Econometrica paper by Ken West. In a follow in a recent JDEC paper with Akito Matsumoto, Pieteo Cova and Massimiliano Pisani, we show that West’s
    partial equilibrium result can be overturned in general equilibrium. But in genral news shocks lead to lower not higher volatility. It is thus paradoxical to model volatility shocks as news shocks.

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