Uncertainty Shocks in a Model of Effective Demand

By Brent Bundick, Research and Policy Advisor and Susanto Basu

  Download paper, RWP 14-15, November 2014; Revised November 2016

Can increased uncertainty about the future cause a contraction in output and its components? An identified uncertainty shock in the data causes significant declines in output, consumption, investment, and hours worked. Standard general-equilibrium models with flexible prices cannot reproduce this comovement. However, uncertainty shocks can easily generate comovement with countercyclical markups through sticky prices. Monetary policy plays a key role in offsetting the negative impact of uncertainty shocks during normal times. Higher uncertainty has even more negative effects if monetary policy can no longer perform its usual stabilizing function because of the zero lower bound. We calibrate our uncertainty shock process using fluctuations in implied stock market volatility and show that the model with nominal price rigidity is consistent with empirical evidence from a structural vector autoregression. We argue that increased uncertainty about the future likely played a role in worsening the Great Recession.

JEL Classification: E32, E52   

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Brent Bundick's research interests include macroeconomics, monetary policy, and computational economics. Read his bio.