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Session 8: The Macroeconomics of Uncertainty and Volatility

August 21-23, 2019 | Landau Economics Bldg, 579 Serra Mall, Rm 134, Stanford

The session will cover recent work on the causes and effects of changes in volatility and uncertainty in the aggregate economy, which is incredibly topical given the ongoing Brexit turmoil and US election outcomes. Many observers, including policymakers such as Bernanke, Summers and Romer, have highlighted that these have been major driving factors in the recent credit-crunch recession and advanced heuristic arguments of why this might have been the case. Unfortunately, our theoretical and empirical understanding of these topics is limited since only recently have macroeconomists started working on these issues from a more systematic basis. Nevertheless, the preliminary results in the literature, to which all four of us have contributed, are rather encouraging. Changes in volatility and uncertainty similar to the ones observed for the U.S. economy can be shown to be quantitatively significant factors in business cycle fluctuations and a key element in a successful explanation of aggregate fluctuations. Moreover, the presence of changes in volatility and uncertainty has important implications for the design of optimal policies and for our assessment of the responses of central banks and fiscal authorities to recent developments in the world economy. Therefore, the session will aim to include about 20 recent papers on these topics. Our goal is to have a balanced mix of theoretical and empirical papers and a strong interest in applications to policy.

Organizers: Nick Bloom (Stanford), Steve Davis (University of Chicago), Jesus Fernandez-Villaverde (University of Pennsylvania) and John Rogers (Federal Reserve Board)

In this Session

Aug 21 | 11:30 am to 1:00 pm


Aug 21 | 12:00 pm to 1:00 pm


Aug 21 | 1:00 pm to 1:40 pm

Economic Policy Uncertainty in China Since 1949: The View from Mainland Newspapers

Presented by: Steven Davis (University of Chicago)
Co-Author(s): Dingqian Liu (American University) and Xuguang S. Sheng (American University)

We quantify economic policy uncertainty (EPU) in China since 1949, as filtered through the lens of two leading mainland newspapers. Like Baker, Bloom and Davis (BBD), we use scaled frequency counts of newspaper articles that contain selected terms to quantify EPU. Unlike BBD, we rely on natural language processing tools to help select policy-relevant terms. Our evidence suggests that mainland newspapers yield a reasonable proxy for EPU in China since the mid 1990s and possibly earlier. Our index is highly elevated during the Korean War, rises sharply in 1979 amidst tensions over market-based reforms and responds to many other domestic and foreign developments that include Ronald Reagan’s election as U.S. President in 1980, political battles over the role of market forces in 1986-1987, German reunification in 1990, the Global Financial Crisis of 2008-2009, and, especially, rising trade policy tensions in 2017-2018. In VAR models fit to data since 1992, surprise increases in our EPU index foreshadow deteriorations in China’s economic performance. Our trade policy uncertainty index for China skyrockets in 2018. Contemporaneously, Chinese firms with high sales to the U.S. saw large negative equity returns and large increases in return volatilities relative to other Chinese firms.

Aug 21 | 1:40 pm to 2:20 pm

Ex ante uncertainty and the Euro Area Business Cycle

Presented by: Geoff Kenny (European Central Bank)

We propose a new survey-based measure of aggregate ex-ante uncertainty for the euro area to assess the relevance of uncertainty shocks at business cycle frequencies. The proposed measure combines information about the disagreement concerning future outcomes for key macro variables with information on their expected conditional volatilities as perceived by individual forecasters. We then exploit information delays and the timing of the survey to identify an exogenous uncertainty shock in a medium-sized Bayesian Vector Auto Regression (BVAR) and trace out the transmission of these shocks via both real and financial sector variables. The relevance of uncertainty shocks during the Great Recession and subsequent sovereign debt crisis in the euro area is then assessed both in sample and in terms of out-of-sample prediction. We find a strong role for our identified ex-ante uncertainty shock as a driver of euro area business cycles, with the financial sector response playing an important role in the propagation of such shocks. Also, a real time out-of-sample forecasting evaluation highlights the relevance of ex-ante uncertainty measures in improving the predictions of credit dynamics as well as bank lending and corporate bond spreads.

Aug 21 | 2:20 pm to 3:00 pm

The Economic Effects of Trade Policy Uncertainty

Presented by: Dario Caldara (Federal Reserve Board)
Aug 21 | 3:00 pm to 3:30 pm


Aug 21 | 3:30 pm to 4:10 pm

Global Risk Aversion and International Return Comovements

Presented by: Nancy R. Xu (Boston College)

I establish three stylized facts about global equity and bond return comovements: Equity return correlations are higher, asymmetric, and countercyclical, whereas bond return correlations are lower, symmetric, and weakly procyclical. I formulate a dynamic no-arbitrage asset pricing model that prices international equities and bonds consistently, and features multiple time-varying global macroeconomic uncertainties and time varying risk aversion of a global investor. All three stylized facts are explainable by the different sensitivities of equity returns (strongly negative) and bond returns (weakly positive or negative) to global risk aversion shocks. Global risk aversion explains 90% (40%) of the fitted global equity (bond) comovements.

Aug 21 | 4:10 pm to 4:50 pm

Price Setting and Volatility: Evidence from Oil Price Volatility Shocks

Presented by: Matt Klepacz (College of William and Mary)

How do changes in aggregate volatility alter the impulse response of output to monetary policy? To analyze this question, I study whether individual prices in Producer Price Index micro data are more likely to move in the same direction when aggregate volatility is high, which would increase aggregate price flexibility and reduce the effectiveness of monetary policy. Taking advantage of plausibly exogenous oil price volatility shocks and heterogeneity in oil usage across industries, I find that price changes are more dispersed, implying that prices are less likely to move in the same direction when aggregate volatility is high. This contrasts with findings in the literature about idiosyncratic volatility. I use a state-dependent pricing model to interpret my findings. Random menu costs are necessary for the model to match the positive empirical relationship between oil price volatility and price change dispersion. This is the case because random menu costs reduce the extent to which firms with prices far from their optimum all act in a coordinated fashion when volatility increases. The model implies that increases in aggregate volatility do not substantially reduce the ability of monetary policy to stimulate output.

Aug 21 | 4:50 pm to 5:30 pm

Skewed Business Cycles

Presented by: Sergio Salgado (The Wharton School, University of Pennsylvania)
Co-Author(s): Fatih Guvenen (University of Minnesota) and Nicholas Bloom (Stanford University)

Using firm-level panel data from the US Census Bureau and more than forty
other countries, we show that the skewness of the growth rate of employment and sales is procyclical. In particular, during recessions, they display a large left tail of negative growth rates (and during booms, a large right tail of positive growth rates). These results are robust to different selection criteria, across countries, industries, and measures. We find similar results at the industry level: industries with falling growth rates see more left-skewed growth rates of firm sales and productivity. We then build a heterogeneous-agent model in which entrepreneurs face shocks with time-varying skewness that matches the firm-level distributions we document for the United States. Our quantitative results show that a negative shock to the skewness of firms’ productivity growth (keeping the mean and variance constant) generates a significant and persistent drop in output, investment, hiring, and consumption.

Aug 21 | 5:30 pm

Drinks and dinner

Aug 22 | 9:00 am to 9:30 am


Aug 22 | 9:30 am to 10:00 am

How Well Does Economic Uncertainty Forecast Economic Activity?

Presented by: Jiawen Xu (Shanghai University of Finance and Economics)
Co-Author(s): John Rogers (Federal Reserve Board)
Aug 22 | 10:00 am to 10:30 am

When It Rains It Pours: Cascading Uncertainty Shocks

Presented by: Alex Hsu (Georgia Institute of Technology)
Co-Author(s): Anthony M. Diercks (Federal Reserve Board) and Andrea Tamoni (London School of Economics)

Uncertainty shocks can be self-reinforcing. We empirically document that serial uncertainty shocks are (1) common in the data and (2) have an increasingly stronger impact on the macroeconomy. In other words, a series of bad (positive) uncertainty shocks exacerbates the economic decline significantly. We then generate the cascading effect of uncertainty shocks in a standard DSGE model. Related to this finding is the non-linear scaling effect of large positive uncertainty shocks. As the size of the positive shock doubles, the macroeconomic response more than doubles. Standard theoretical models solved under third order perturbation cannot generate these empirical results: a fourth order perturbation solution is crucial.

Aug 22 | 10:30 am to 11:00 am


Aug 22 | 11:00 am to 11:30 am

Uncertainty and Expectation Formation over the Business Cycles: Evidence from Japan and the Globe

Presented by: Cheng Chen (Clemson)
Co-Author(s): Tatsuro Senga (Queen Mary University of London), Chang Sun (The University of Hong Kong) and Hongyong Zhang (RIETI)
Aug 22 | 11:30 am to 12:00 pm

The World Uncertainty Index

Presented by: Davide Furceri (International Monetary Fund)
Co-Author(s): Ahir Hites (International Monetary Fund) and Nicholas Bloom (Stanford University)

We construct a new index of uncertainty—the World Uncertainty Index (WUI)—for 143 individual countries on a quarterly basis from 1996 onwards, and for 34 large advanced and emerging market economies from 1955. This is  defined using the frequency of the word “uncertainty” in the quarterly Economist Intelligence Unit country reports. Globally, the Index spikes near the 9/11 attack, the SARS outbreak, the Gulf War II, the failure of Lehman Brothers, the Euro debt crisis, El Niño, the European border crisis, the UK Brexit vote, the 2016 US election and the recent US-China trade tensions. Uncertainty spikes tend to be more synchronized within advanced economies and between economies with tighter trade and financial linkages. The level of uncertainty is significantly higher in developing countries and is positively associated with economic policy uncertainty and stock market volatility, and negatively with GDP growth. In addition, there is an inverted U-shaped relationship between uncertainty and democracy. In a panel vector autoregressive setting, we find that innovations in the WUI foreshadow significant declines in output. This effect varies across countries and across sectors within the same country: across countries, the effect is larger and more persistent in those with lower institutional quality; across sectors, the effect is stronger in those more financially-constrained.

Aug 22 | 12:00 pm to 12:30 pm

The Impact of Uncertainty Shocks: Evidence from Geopolitical Swings on the Korean Peninsula

Presented by: Seohyun Lee (IMF and Bank of Korea)
Co-Author(s): Jongrim Ha (World Bank) and Inhwan So (Bank of Korea)
Aug 22 | 12:30 pm to 1:30 pm


Aug 22 | 1:30 pm to 2:00 pm

Market-Based Monetary Policy Uncertainty

Presented by: Michael Bauer (Federal Reserve Bank of San Francisco)
Co-Author(s): Aeimit Lakdawala (Michigan State University) and Philippe Mueller (Warwick Business School)

This paper investigates the role of monetary policy uncertainty for the transmission of FOMC actions to financial markets using a novel model-free measure of uncertainty based on derivative prices. We document a systematic pattern in monetary policy uncertainty over the course of the FOMC meeting cycle: On FOMC announcement days uncertainty tends to decline substantially, indicating the resolution of policy uncertainty. This decline is then reversed over the first two weeks of the intermeeting FOMC cycle. Both the level and the changes in uncertainty play an important role for the transmission of monetary policy to financial markets. First, changes in uncertainty have substantial effects on a variety of asset prices that are distinct from the effects of the conventional policy surprise measure. For example, the Fed’s forward guidance announcements affected asset prices not only by adjusting the expected policy path but also by changing market-perceived uncertainty about this path. Second, at high levels of uncertainty a monetary policy surprise has only modest effects on assets, whereas with low uncertainty the impact is significantly more pronounced.

Aug 22 | 2:00 pm to 2:30 pm

Demand for Information, Uncertainty, and the Response of U.S. Treasury Securities to News

Presented by: Clara Vega (Federal Reserve Board of Governors)
Co-Author(s): Hedi Benamar (Federal Reserve Board of Governors) and Thierry Foucault (HEC Paris)
Aug 22 | 2:30 pm to 3:00 pm

Search Complementarities and Aggregate Fluctuations

Presented by: Jesus Fernandez-Villaverde (University of Pennsylvania
Co-Author(s): Federico Mandelman (Federal Reserve Bank of Atlanta), Yang Yu (Shanghai University of Finance and Economics) and Franceso Zanetti (University of Oxford)

We develop a quantitative business cycle model with search complementarities in the interfirm matching process that entails a multiplicity of equilibria. An active static equilibrium with strong joint venture formation, large output, and low unemployment can coexist with a passive static equilibrium with low joint venture formation, low output, and high unemployment. Changes in fundamentals move the system between the two static equilibria, generating large and persistent business cycle fluctuations. The volatility of shocks is important for the selection and duration of each static equilibrium. Sufficiently adverse shocks in periods of low macroeconomic volatility trigger severe and protracted downturns. The magnitude of government intervention is critical to foster economic recovery in the passive static equilibrium, while it plays a limited role in the active static equilibrium 

Aug 22 | 3:00 pm to 3:30 pm


Aug 22 | 3:30 pm to 4:00 pm

Firm Uncertainty and Household Spending

Presented by: Ivan Alfaro (BI Norwegian Business School, Oslo)
Co-Author(s): Hoonsuk Park (Nanyang Technological University)

We map rich micro-data from financial accounts of US households to employers listed in the US stock market. Using banking and credit card transaction data, we find that households adjust their consumption spending in response to labour income uncertainty, as proxied by employer specific option-implied volatility. Households reduce average monthly consumption growth by 1.28 points in response to a one standard deviation increase in firm uncertainty. This negative 2nd moment firm uncertainty effect is larger than a positive 1st moment effect of firm stock returns. The intensity of the response increases in the forecast horizon window, lasts up to a year, and is more pronounced for low-income households. Retail spending is more responsive than groceries and restaurant purchases. Employees that work at firms that recently had low employee growth, high intangible investment, low return on assets, low Tobin’s Q, and risky high CAPM β firms show pronounced consumption sensitivity to firm volatility shocks. Households randomly mapped to placebo employers show no response to firm uncertainty.

Aug 22 | 4:00 pm to 4:30 pm

The Effect of Health Care Policy Uncertainty on Households' Consumption and Portfolio Choice

Presented by: Thomas T. Wiemann (University of Chicago)
Co-Author(s): Robin L. Lumsdaine (Kogod School of Business, American University)

While health care reform continues to be a major topic of policy debate in the United States, rising costs of treatment make potential medical expenditures an increasingly important contributor to households’ financial risk. To investigate the effect of health care policy uncertainty (HCPU) on households, we develop a simple theoretical model that predicts a negative effect of HCPU on consumption and the relative demand for risky financial assets versus safe assets. The model illustrates that the HCPU effect increases with bad health. We combine rich longitudinal data on older Americans with a recently developed HCPU index to test these claims, using two approaches adapted from the machine learning literature. The results indicate an important effect of HCPU on portfolio choice but provide mixed evidence for the HCPU effect on households’ total spending. Further empirical estimates corroborate the theoretical prediction that this effect is increasing in households’ health problems.

Aug 22 | 4:30 pm to 5:00 pm

Macroeconomic and Financial Risks: A Tale of Volatility

Presented by: Dario Caldara (Federal Reserve Board)
Aug 22 | 5:00 pm

Drinks and dinner

Aug 23 | 8:00 am to 8:30 am


Aug 23 | 8:30 am to 9:10 am

Real Credit Cycles

Presented by: Stephen Terry (Boston University)
Co-Author(s): Pedro Bordalo (University of Oxford), Nicola Gennaioli (Universita Bocconi) and Andrei Shleifer (Harvard University)

Recent empirical work has revived the Minsky hypothesis of boom-bust credit cycles driven by fluctuations in investor optimism. To quantitatively assess this hypothesis, we incorporate diagnostic expectations into an otherwise standard business cycle model with heterogeneous firms and risky debt. Diagnostic expectations are a psychologically founded, forward-looking model of belief formation that captures over-reaction to news. We calibrate the diagnosticity parameter using micro data on the forecast errors of managers of listed firms in the US. The model generates countercyclical credit spreads and default rates, while the rational expectations version generates the opposite pattern. Diagnostic expectations also offer a good fit of three patterns that have been empirically documented: systematic reversals of credit spreads, systematic reversals of aggregate investment, and predictability of future bond returns. Crucially, diagnostic expectations also generate a strong fragility or sensitivity to small bad news after steady expansions. The rational expectations version of the model can account for the first pattern but not the others. Diagnostic expectations offer a parsimonious account of major credit cycles facts, underscoring the promise of realistic expectation formation for applied business cycle modeling.

Aug 23 | 9:10 am to 9:50 am

Borrowing to Save and Investment Dynamics

Presented by: Jasmine Xiao (University of Notre Dame)

Existing literature on financial frictions argue that firms reduce investment in a crisis due to a lack of credit. However, U.S. public firms, which together accounted for 89 percent of the decline in investment during the Great Recession, experienced no drop in borrowing. Instead of investing, they borrowed to expand their stock of safe assets; that is, they borrowed to save. I model borrowing to save as an optimal portfolio choice when firms face gradually resolving uncertainty. In a quantitative general equilibrium model with heterogeneous firms, I show that this mechanism can simultaneously
generate a sharp downturn and a slow recovery.

Aug 23 | 9:50 am to 10:30 am

Risk-Adjusted Capital Allocation and Misallocation

Presented by: Joel David (USC)
Co-Author(s): Lukas Schmid (Duke University) and David Zeke (USC)

We develop a theory linking “misallocation,” i.e., dispersion in marginal products of capital (MPK), to systematic investment risks. Firms differ in their exposure to these risks, which we show leads naturally to heterogeneity in firm-level risk premia and, more importantly, MPK. Cross-sectional dispersion in MPK (i) depends on cross-sectional dispersion in risk exposures and (ii) fluctuates with the price of risk, and thus is countercyclical. We document strong empirical support for these predictions. We devise a strategy to quantify dispersion in risk exposures using data on expected stock market returns. Our estimates imply that risk considerations explain almost 40% of observed MPK dispersion among US firms and can rationalize a large persistent component in firm-level MPK. MPK dispersion induced by risk premium effects, although not prima facie inefficient, lowers the average level of aggregate productivity by as much as 7%, suggesting large “productivity costs” of business cycles.

Aug 23 | 10:30 am to 10:50 am


Aug 23 | 10:50 am to 11:20 am

Dymamic Effects of News Shocks Under Uncertainty

Presented by: Danilo Cascaldi-Garcia (Federal Reserve Board)

This paper bridges two strands of the literature of business cycles driven by agents’ beliefs: news shocks and uncertainty. I propose an estimation and identification procedure that allows investigating the empirical relationship between agents’ responses to future technological improvements and the level of uncertainty in the economy. I show that the economic responses to news shocks change substantially over time, and uncertainty endogenously reacts to it. Macroeconomic uncertainty reduces after a news shock, in response to the increase in the information about the expected future path of the economy. Financial uncertainty initially increases after a news shock, in line with the idea of ‘good uncertainty’. The financial uncertainty rapidly resolves, as the market converges to a consensus about the interpretation of the news. Periods of high financial uncertainty are characterized by higher positive economic effects of news shocks on output, consumption and investment. These results indicate that the continuous updating of agents’ expectations about the current and future economic situation operates as a transmission channel for news shocks.

Aug 23 | 11:20 am to 12:00 pm

Impact of Brexit on UK Firms

Presented by: Scarlet Chen (Stanford University)
Co-Author(s): Nicholas Bloom (Stanford University), Philip Bunn (Bank of England), Paul Mizen (University of Nottingham) and Pawel Smietanka (Bank of England)

We use a major new survey of UK firms, the Decision Maker Panel, to assess the impact of the June 2016 Brexit referendum. We identify three key results. First, the UK’s decision to leave the EU has generated a large, broad and long-lasting increase in uncertainty. Second, anticipation of Brexit is estimated to have gradually reduced investment by about 11% over the three years following the June 2016 vote. This fall in investment took longer to occur than predicted at the time of the referendum, suggesting that the size and persistence of this uncertainty may have delayed firms’ response to the Brexit vote. Finally, the Brexit process is estimated to have reduced UK productivity by between 2% and 5% over the three years after the referendum. Much of this drop is from negative within-firm effects, in part because firms are committing several hours per week of top-management time to Brexit planning. We also find evidence for smaller negative between-firm effects as more productive, internationally exposed, firms have been more negatively impacted than less productive domestic firms.

Aug 23 | 12:00 pm