Uncertainty and Business Cycles: Measurement, Theory, and Policy

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

Uncertainty and Business Cycles: Measurement, Theory, and Policy Intellectual Merit What is the impact of economic uncertainty on business cycle fluctuations? This long-standing question has achieved increased prominence during the current economic downturn, which has been accompanied by a surge in uncertainty. At the height of the crisis, most measures of economic uncertainty had reached unprecedented levels and key policy makers, such as Larry Summers, Christina Romer, Olivier Blanchard and Ben Bernanke have all repeatedly commented on the damaging impact of economic uncertainty on the US economy. The research described in this proposal focuses on the interaction between time-varying uncertainty and the business cycle. It concentrates on the direct effect of uncertainty on aggregate economic activity, through the option value of delaying projects on firm decisions, and its implication for the effectiveness of government policy. Specifically, the PI's intend to address the following questions, both from empirical as well as theoretical grounds. 1. What is the empirical behavior of uncertainty over the business cycle? The PI's build various proxies for uncertainty and preliminary results suggest that these proxies are strongly countercyclical. 2. What is the role of time-varying uncertainty as a driver of business cycle fluctuations? To quantify the potential effects of the mechanism, the PI's develop a dynamic stochastic general equilibrium model with second-moment shocks. According to the preliminary simulations, variation in uncertainty can lead to significant fluctuations in economic activity. 3. What is the effect of time variation in uncertainty on policy effectiveness?The PI's intend to analyze the effects of government policy in the context of the model. Preliminary evidence suggests that the effect of stimulative policies is significantly mitigated in times of heightened uncertainty. To address these questions the PI's propose a 3-year project combining both micro-to-macro theory and empirics. The model has heterogeneous firms in a dynamic general equilibrium economy. The data will combine macro, industry, firm, establishment and product data from 1972 to 2010, allowing the PI's to analyze six recessions including the current credit-crunch. Broader Impact The results of this research will provide a better understanding of how economic uncertainty affects business cycle fluctuations and a better understanding of the nature of business cycle fluctuations in industrialized countries. Such knowledge is crucial for the design of government policy that has the aim of stabilizing the economy. Given the recent surge in uncertainty there is strong policy need to study the e¤ects of uncertainty. This is true both in terms of its direct impact on the economy, as well as its impact on the effectiveness of a range of potential policies. Preliminary results suggest that the time variation in uncertainty has a significant effect on business cycle volatility and on the effectiveness of policy as the presence of uncertainty mitigates the impact of such a policy relative to its impact during low uncertainty times. The second broader impact is empirical. The project aims to use the Census data to construct and make publicly available time series indices of micro uncertainty. To date this has not been done. Publicly available annual measures of establishment level uncertainty will be extremely valuable to a wide range of researchers. As a part of this project, the PI's will also develop a methodology for measuring uncertainty in Census data that tackles issues over samples (e.g., manufacturing, retail or all establishments), preferred measures (sales, employment or TFP) and concepts (realized outcomes versus prediction errors).