Uncertainty and the business cycle

Two important papers on the booming literature about uncertainty this week. They show that uncertainty matters a lot and can have lasting effects on the state fo the economy and the effectiveness of policy. This keeps silent, however, how policy can influence uncertainty. Interesting stuff that should prompt more work.

Uncertainty Traps

By Pablo Fajgelbaum, Edouard Schaal and Mathieu Taschereau-Dumouchel

http://d.repec.org/n?u=RePEc:nbr:nberwo:19973&r=dge

We develop a theory of endogenous uncertainty and business cycles in which short-lived shocks can generate long-lasting recessions. In the model, higher uncertainty about fundamentals discourages investment. Since agents learn from the actions of others, information flows slowly in times of low activity and uncertainty remains high, further discouraging investment. The unique equilibrium of this economy displays uncertainty traps: self-reinforcing episodes of high uncertainty and low activity. While the economy recovers quickly after small shocks, large temporary shocks may have nearly permanent effects on the level of activity. The economy is subject to an information externality but uncertainty traps remain even in the efficient allocation. We extend our framework to include additional features of standard business cycle models and show, in that context, that uncertainty traps can substantially worsen recessions and increase their duration, even under optimal policy interventions.

Really Uncertain Business Cycles

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

http://d.repec.org/n?u=RePEc:cen:wpaper:14-18&r=dge

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.

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3 Responses to Uncertainty and the business cycle

  1. Nick says:

    thanks Christian – i think the two key areas in this work on the empirical front are measurement and identification. On measurement our measures of uncertainty are fine but not perfect, in large part because uncertainty is a subjective concept in the minds of agents and it’s very hard to get at that. On identification I think this is particularly tricky – basically do recessions cause uncertainty, uncertainty cause recessions or something causes both? Unfortunately there are not many natural experiments in macro so hard to tease this out. This is also a very active area of research so I’m hopeful we’ll make progress on this.

  2. Sam Tiong says:

    I would like to highlight the main theme of this paper By Pablo Fajgelbaum, Edouard Schaal and Mathieu Taschereau-where they claim shocks are forward looking and have some definite channels of transmission. Could it be possible to run back testing on historical data and correlate past shocks to fluctuations in real output? It is evident that new shocks have new features different from the old ones, but how far is it correct to go blindfolded and rely on specific macroeconomic tools (such as DGSE models) in order to forecast future business shocks which could indeed be entirely different in nature? What about uncertainty traps?

    On the empirical frontier, the situation is tricky since you can’t really account for any unaccounted shocks at present without having any data about future uncertain events, say, changes in future expectations about returns. That’s absolute stupidity. However, the authors very commendably modelled the tricky situations in business cycle uncertainties which definitely merit further investigations.

    Did the authors discuss about these aspects?

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