Uncertainty and the business cycle: theory and empirics

Clark, Joshua (2023) Uncertainty and the business cycle: theory and empirics. Doctoral thesis, University of East Anglia.

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Recessions create uncertain economic environments which agents must navigate when making costly decisions. Across four chapters, this thesis adds to the current understanding of how time-varying economic uncertainty can be measured and how it affects real economic activity, especially during times of economic crisis.

The first two chapters introduce a new framework for examining the response of investment to changes in economic regime. Both the price of a firm's output good and its production function depend on a continuous time Markov chain which switches between an expansionary regime and a recessionary regime. The latter is characterised by higher uncertainty about the output price and lower productivity in the production process.

Chapter one models an investor's decision to acquire and sell this firm. Switches between regimes produce various patterns of acquisitions and sales depending on the differences in uncertainty and productivity between the regimes. The model provides a mechanism for explaining the wave like pattern of acquisitions over the business cycle. Chapter two focuses on the active firm's capital accumulation policy. Here, the model can generate lumpy patterns of investment following switches between the regimes, and demonstrates how entering a persistent recessionary regime with high uncertainty and low productivity can lead to extended periods of low investment.

Chapter three estimates the effect of a firm's idiosyncratic uncertainty, as measured by the
volatility its stock returns, on its investment rate using almost 30 years of U.S. data. Consistent with the predictions of the models in the first two chapters, the relationship between the variables is negative. The increase in uncertainty during the Great Recession also played a large role in causing the observed fall in investment. Furthermore, there is evidence that uncertainty has been more of a drag on investment after the Great Recession; firms with growth opportunities sufficient to neutralise its effect before the recession are sensitive to its variation in the years after.

Despite widespread use in the literature, the volatility of stock returns is not an ideal measure of economic uncertainty. Using an instrumental variable SVAR model, chapter four set identifies shocks to uncertainty and stock market volatility and demonstrates that the latter can vary even when there is no change in economic uncertainty. The identified shocks also produce different impulse response functions for several key macroeconomic indicators. The price of gold around events that make the future harder to predict is used as an instrument for uncertainty shocks while exogenous changes in the spread between Baa-rated corporate bonds and the 10-year treasury bond rate is used as a proxy for shocks to stock market volatility.

Item Type: Thesis (Doctoral)
Faculty \ School: Faculty of Social Sciences > School of Economics
Depositing User: Nicola Veasy
Date Deposited: 02 Nov 2023 12:53
Last Modified: 02 Nov 2023 12:53
URI: https://ueaeprints.uea.ac.uk/id/eprint/93535


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