TY - JOUR AU - Basu, Susanto AU - Bundick, Brent TI - Uncertainty Shocks in a Model of Effective Demand JF - National Bureau of Economic Research Working Paper Series VL - No. 18420 PY - 2012 Y2 - September 2012 DO - 10.3386/w18420 UR - http://www.nber.org/papers/w18420 L1 - http://www.nber.org/papers/w18420.pdf N1 - Author contact info: Susanto Basu Department of Economics Boston College 140 Commonwealth Avenue Chestnut Hill, MA 02467 Tel: 617/552-2182 Fax: 617/552-2308 E-Mail: susanto.basu@bc.edu Brent Bundick Federal Reserve Bank of Kansas City Economic Research Department 1 Memorial Drive Kansas City, MO 64198 E-Mail: brent.bundick@kc.frb.org AB - 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. The economic mechanism we identify applies to a large set of shocks that change expectations of the future without changing current fundamentals. ER -