Uncertainty and the business cycle

March 30, 2014

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


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


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.

Asset Prices in a Lifecycle Economy

March 19, 2014

By Roger Farmer


The representative agent model (RA) has dominated macroeconomics for the last thirty years. This model does a reasonably good job of explaining the co-movements of consumption, investment, GDP and employment during normal times. But it cannot easily explain movements in asset prices. Two facts are hard to understand 1) The return to equity is highly volatile and 2) The premium for holding equity, over a safe government bond, is large. This paper constructs a lifecycle model in which agents of different generations have different savings rates and different attitudes to risk and I use this model to account for both a high equity premium and a volatile stochastic discount factor. The model is persuasive, precisely because it explains so much with so few parameters, each of which is pinned down by a few simple facts.

While I do not think the model is as simple and has as few degrees of freedom as Roger Farmer makes it appear, it is quite powerful in resolving the excessive volatility and equity premium puzzles. We have learned that the life cycle matters for many economic issues, and this seems to be another one. While the life cycle is modeled in a very crude way here, it would interesting to see whether the quantitative results would still hold in a model that tracks life events with more granularity.

Optimal Taxation and Life Cycle Labor Supply Profile

March 16, 2014

By Michael Kuklik and Nikita C├ęspedes


The optimal capital income tax rate is 36 percent as reported by Conesa, Kitao, and Krueger (2009). This result is mainly driven by the market incompleteness as well as the endogenous labor supply in a life-cycle framework. We show that this model fails to account for the basic life-cycle features of the labor supply observed in the U.S. data. In this paper, we introduce into this model non-linear wages and inter-vivos transfers into this model in order to account for the life-cycle features of labor supply. The former makes hours of work highly persistent and helps to account for labor choices at the extensive margin over the life cycle. The latter allows us to account for labor choices early in life. The suggested model delivers an optimal capital income tax rate of 7.4 percent, which is significantly lower than what Conesa, Kitao, and Krueger (2009) found.

One more paper in an everexpanding literature on optimal capital income taxation. And once more, it shows how dramatically sensitive results are to modeling assumptions. Is this literature ever going to come to a conclusion? On one hand, this challenge makes it all the more exciting for the researcher, on the other hand, the lack of robustness of results is quite disheartening.

Can Intangible Capital Explain Cyclical Movements in the Labor Wedge?

March 5, 2014

By François Gourio and Leena Rudanko


Intangible capital is an important factor of production in modern economies that is generally neglected in business cycle analyses. We demonstrate that intangible capital can have a substantial impact on business cycle dynamics, especially if the intangible is complementary with production capacity. We focus on customer capital: the capital embodied in the relationships a firm has with its customers. Introducing customer capital into a standard real business cycle model generates a volatile and countercyclical labor wedge, due to a mismeasured marginal product of labor. We also provide new evidence on cyclical variation in selling effort to discipline the exercise.

There are now quite a few papers that look beyond the traditional production factors and their impact on the business cycle. This is probably the most concrete paper that looks at intangible capital, which is obviously difficult to measure, but which manifests itself in ways that can be related to data such as indicators of selling effort. It looks like theory is still ahead of measurement, though.