REALLY UNCERTAIN BUSINESS CYCLES

We investigate the role of uncertainty in business cycles. First, we demonstrate that microeconomic uncertainty rises sharply during recessions, including during the Great Recession of 2007-2009. Second, we show that uncertainty shocks can generate drops in gross domestic product of around 2.5% in a dynamic stochastic general equilibrium model with heterogeneous firms. However, we also find that uncertainty shocks need to be supplemented by first-moment shocks to fit consumption over the cycle. So our data and simulations suggest recessions are best modelled as being driven by shocks with a negative first moment and a positive second moment. Finally, we show that increased uncertainty can make first-moment policies, like wage subsidies, temporarily less effective because firms become more cautious in responding to price changes.