Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Do Households Respond to Uncertainty Shocks?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

How Do Households Respond to Uncertainty Shocks?

Article excerpt

Economic disruptions generally coincide with heightened uncertainty. In the United States, uncertainty increased sharply with the recent housing market crash, financial crisis, deep recession, and uneven recovery. In July 2010 congressional testimony, Federal Reserve Chairman Bernanke described conditions as "unusually uncertain." The uncertain landscape was also cited as a factor in the slow recovery from the 2001 recession, when the March 2003 Federal Open Market Committee statement highlighted the "unusually large uncertainties" at the time.

Uncertainty is a standard feature of most macroeconomic models, in which consumers and firms make decisions today based on expectations of an unknown (and hence uncertain) future. But in light of real-world events, economists have begun to think more critically about the role of uncertainty in the economy. Recent research has allowed the degree of uncertainty to vary over time and examined how these fluctuations affect business activity. The results have been mixed thus far, with some authors finding that fluctuations in uncertainty are a key factor in the business cycle, while others have found little such evidence.

This article takes a similar approach in studying levels of uncertainty that can vary over time, but it focuses on household responses to changes in uncertainty. Because uncertainty can take many forms, the article considers two measures of uncertainty: one based on references to uncertainty in newspaper articles and another derived from the stock market.

While economic theory predicts sudden, sharp pullbacks of household purchases following increases in uncertainty, the empirical results suggest that household spending reductions are modest and may only appear after a considerable time has passed. In addition, movements in uncertainty account for only a small portion of the total fluctuations in household spending. These results suggest that variations in the amount of uncertainty-at least as they are commonly captured-do not appear to be a key factor driving household spending decisions and, in turn, economic weakness.

The first section of this article provides a framework for thinking about uncertainty and how it affects economic activity. The second section describes two separate measures that have been proposed by economists to quantify uncertainty. The third section assesses the importance of fluctuations in uncertainty on household purchases, first using a simple bivariate model and then using a model that incorporates more relevant information.

I. A FRAMEWORK FOR UNCERTAINTY SHOCKS AND ECONOMIC ACTIVITY

Uncertainty is an important feature of the real world and plays a central role in modern macroeconomics. Yet uncertainty can be interpreted in a number of ways. To fix ideas, this section provides a framework for thinking about uncertainty and how it might change over time. With this framework in place, the section then considers how economic agents respond to fluctuations in uncertainty in theoretical models. The common theme of these theories is that an increase in uncertainty tends to dampen spending immediately, as businesses and consumers enter a "wait-and-see" mode. This response is especially characteristic of expensive purchases that are difficult to undo. Over time, as the increase in uncertainty wears off, economic activity tends to rebound sharply.

What is an uncertainty shock?

Economic models incorporate uncertainty about the future through random disturbances, or shocks. For example, a household may know its wealth today, but its wealth tomorrow may be uncertain because it is subject to shocks that are ultimately beyond the household's control.

To analyze the effects of such shocks, economists usually assume that the probability distribution of the shocks-that is, the likelihood of a shock of a given size occurring-is both known and constant over time. The blue bars in Chart 1 provide an example of a distribution of shocks that can affect future wealth. …

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