We propose uncertainty shocks as a new shock that drives business cycles. First, we demonstrate that microeconomic uncertainty is robustly countercyclical, rising sharply during recessions, particularly during the Great Recession of [2007][2008][2009]. Second, we quantify the impact of timevarying uncertainty on the economy in a dynamic stochastic general equilibrium model with heterogeneous firms. We find that reasonably calibrated uncertainty shocks can explain drops and rebounds in GDP of around 3%. Moreover, we show that increased uncertainty alters the relative impact of government policies, making them initially less effective and then subsequently more effective.JEL classification: E3

We thank the U.S. National Science Foundation, the Sloan Foundation, and the University of Chicago Booth School of Business for financial support. We also thank Steve Tadelis and Wolfgang Keller for valuable comments on the paper. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. At least one co-author has disclosed a financial relationship of potential relevance for this research. Further information is available online at http://www.nber.org/papers/w26983.ack NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

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.

We propose uncertainty shocks as a new shock that drives business cycles. First, we demonstrate that microeconomic uncertainty is robustly countercyclical, rising sharply during recessions, particularly during the Great Recession of [2007][2008][2009]. Second, we quantify the impact of timevarying uncertainty on the economy in a dynamic stochastic general equilibrium model with heterogeneous firms. We find that reasonably calibrated uncertainty shocks can explain drops and rebounds in GDP of around 3%. Moreover, we show that increased uncertainty alters the relative impact of government policies, making them initially less effective and then subsequently more effective.JEL classification: E3