The long-run effects of uncertainty shocks

Dario Bonciani and Joonseok Jason Oh

Is uncertainty a significant drag for investment and consumption? Since the global financial crisis heightened uncertainty has been considered to be one of the main factors behind the depth of the great recession and the subdued recovery. Understanding the channels through which uncertainty affects economic activity is therefore of primary interest for policymakers in order to design appropriate policy responses. In our recent working paper, we show that shocks increasing macroeconomic uncertainty can lead to very persistent negative effects on economic activity that last well beyond the business cycle frequency. In a theoretical framework, we argue that the presence of long-term risks about the economic outlook can exacerbate the households’ precautionary savings motive and the overall effects of uncertainty shock.

How does uncertainty affect the economy?

The main channels that are typically discussed in the literature are, on the households’ side, the precautionary savings channel, which leads households to reduce their consumption and supply more labour when the economic outlook looks particularly uncertain; on the production side, the real options channel (or wait-and-see channel) that induces firms to delay their investments and wait-and-see until the uncertainty surrounding their profit possibilities has reduced.

Some empirical evidence

While uncertainty shocks are usually seen as having short-term effects on the economy, in our paper, we argue that these effects can be potentially very long-lasting. To provide empirical evidence of this argument, we estimate a Vector Autoregressive model (VAR) for the US and analyse how the variables included in the model respond to a one-time increase in macroeconomic uncertainty. In the baseline exercise, we use the measure of uncertainty estimated by Jurado et al (2015), who define uncertainty as the common volatility of the unforecastable component of many macroeconomic indicators. We identify an uncertainty shock by assuming that uncertainty is not contemporaneously affected by the other endogenous variables in the model, except for the S&P500, which is included to control for potential movements in the stock market.

As shown in Figure 1, an increase in uncertainty causes a fall in the main macroeconomic aggregates that lasts for over 10 years. In particular, from our investigation, it emerges that a one-standard-deviation shock to macroeconomic uncertainty, reduces GDP, consumption, and R&D investment respectively by 0.4, 0.3, and 0.6 per cent within the first 8 quarters. This downturn is particularly persistent and the 68% per cent confidence interval for the responses of all the variables mentioned above remains below zero after 40 quarters. Furthermore, we find a significant and persistent reduction in total factor productivity (TFP), the main driver of long-run economic growth.

Figure 1: The effects of a macroeconomic uncertainty shock

Shaded grey areas represent 90% and 68% confidence bands.

A DSGE model with endogenous growth

We build and estimate a Dynamic Stochastic General Equilibrium (DSGE) model to rationalise the empirical results. In this framework, households consume, supply labour to firms and invest their savings in riskless bonds, in physical capital and in research and development (R&D). Households feature preferences a` la Epstein-Zin, which make them averse to risks about the long-term economic outlook. Firms are monopolistically competitive and combine the labour, capital and R&D inputs coming from the household to produce a final good. Firms’ productivity consists of an endogenous component, which positively depends on the aggregate stock of R&D, and an exogenous component that is subject to “TFP shocks”. We define an uncertainty shock as an unexpected increase in the variance of TFP shocks. In other words, an uncertainty shock increases the probability of extreme (both positive and negative) TFP shocks occurring in the future. The economy will grow following a trend that is endogenously determined by the stock of R&D. This feature allows us to analyse the effects of shocks to uncertainty on economic activity both in the short- and in the long-run.

In such a model, uncertainty shocks lead to a short-term fall in demand because of precautionary savings and an increase in firms’ price markups. The fall in demand reduces firms’ demand for labour, physical capital and most importantly R&D. In turn, the decline in R&D leads to a fall in productivity, which explains the long-term fall in the main macroeconomic aggregates. Given the strong fall in output, the central bank cuts the interest rate on impact, in order to sustain demand in the short-term.

Quantitative results of our model

Figure 2 shows the responses of the variables in our model to an uncertainty shock in the model. As can be seen from Figure 2, the estimated model is able to reproduce what we observed in the data, both from a qualitative and a quantitative point of view. That is, in the model, a shock to uncertainty generates persistent falls in output, consumption, R&D investment and TFP of a similar magnitude to the empirical evidence shown in Figure 1.

Figure 2: The effects of a TFP uncertainty shock (DSGE)

Standard business cycle models struggle to obtain sizable effects from rises in uncertainty. For example papers like Born and Pfeifer (2014) and Cesa-Bianchi and Fernandez-Corugedo (2018) find macroeconomic uncertainty not to be a relevant driver of business cycle fluctuations. Our model presents two important distinctive features: first, the endogenous growth mechanism described above that allows uncertainty shocks to have long-term effects; and second, the Epstein-Zin preferences, which introduce a strong nonlinearity in our model and make agents care more about risk regarding their long-term consumption. The combination of the two represents the key source of amplification of uncertainty shocks in our model. When compared with alternative model specifications that abstract from one of the two features (or both), the effects are 2 orders of magnitude larger.

Back to where we started, can uncertainty shocks be a significant drag on consumption and investment?

Yes. In our theoretical model, by internalising risks about the long-term economic outlook, households become extremely risk averse, which notably exacerbates their precautionary savings motive and the overall negative effects of uncertainty. The mechanism we propose is complementary to other sources of amplification that have been identified in the literature, such as the Zero Lower Bound and frictions in the financial sector or in the labour market. We think that future research should further investigate and explore alternative sources of nonlinearities that could affect the transmission of uncertainty and other macroeconomic shocks. #

Dario Bonciani works in the Bank’s MPOD-Modelling Team and Joonseok Jason Oh works at the European University Institute.

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