Demand shocks create firm uncertainty, amplify business cycles
A new Federal Reserve study examines how firm-level uncertainty arises over the business cycle and influences aggregate economic activity. It finds that demand shocks generate endogenous uncertainty, amplifying business cycles.
Credit shocks fuel firm uncertainty
This study develops a general equilibrium incomplete-markets model with heterogeneous, risk-averse firms facing idiosyncratic demand uncertainty and aggregate shocks to consumer credit conditions.
A change in aggregate credit affects not only the expected level of firm demand but also the cross-sectional dispersion of sales per worker by shifting the probability that firms operate at capacity.
Thus, first-moment shocks give rise to endogenous second-moment effects.
The model, disciplined using U.S. Compustat data, reproduces key cross-sectional moments and business-cycle comovements, including countercyclical dispersion in firm outcomes.
Quantitatively, endogenous uncertainty accounts for roughly one quarter of the output response and one third of the employment response to aggregate credit shocks.
The results suggest uncertainty is an endogenous propagation mechanism through which demand changes amplify business cycles.
Uncertainty's endogenous roots
Uncertainty fluctuations are large and strongly countercyclical, with documented adverse effects on economic activity and inflation.
While the negative relationship between uncertainty and aggregate activity is clear, its origins are less evident.
Most research has focused on the effects of uncertainty, often assuming exogenous shocks.
However, recent empirical work suggests that some measured uncertainty behaves endogenously, rising in response to adverse macroeconomic shocks rather than acting solely as independent impulses.
This study aims to provide evidence for these potential origins, delivering a quantitative theory consistent with time-varying cross-sectional properties of U.S. macroeconomic aggregates.
Uncertainty's dual role
This paper significantly advances understanding by modeling uncertainty as an endogenous factor, not just an external shock.
Its quantitative findings highlight a substantial amplification mechanism for business cycles, making it highly relevant for policy responses to demand-side disturbances.
The framework offers a more nuanced view of economic fluctuations, moving beyond simplistic exogenous volatility assumptions.