Universities Research Conference

Pedro Bordalo, University of London; Nicola Gennaioli, Bocconi University; and Andrei Shleifer, Harvard University and NBER

Stereotypes (NBER Working Paper 20106)

Bordalo, Gennaioli, and Shleifer present a model of stereotypes in which a decision maker assessing a group recalls only that group's most representative or distinctive types relative to other groups. Because stereotypes highlight differences between groups, and neglect likely common types, they are especially inaccurate when groups are similar. In this case, stereotypes consist of unlikely, extreme types. When stereotypes are inaccurate, they exhibit a form of base rate neglect. They also imply a form of confirmation bias in light of new information: beliefs over-react to information that confirms the stereotype and ignore information that contradicts it. However, stereotypes can change – or rather, be replaced – if new information changes the group's most distinctive trait. Applied to gender stereotypes, the model provides a unified account of disparate evidence regarding the gender gap in education and in labor markets. The authors also use the model to explore the determinants of neglected risks in financial markets.

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Anna Orlik, Federal Reserve Board, and Laura Veldkamp, New York University and NBER

Understanding Uncertainty Shocks and the Role of Black Swans

A fruitful emerging literature reveals that shocks to uncertainty can explain asset returns, business cycles and financial crises. The literature equates uncertainty shocks with changes in the variance of an innovation whose distribution is common knowledge. But how do such shocks arise? Orlik and Veldkamp argue that people do not know the true distribution of macroeconomic outcomes. Like Bayesian econometricians, they estimate a distribution. Using real-time GDP data, the authors measure uncertainty as the conditional standard deviation of GDP growth, which captures uncertainty about the distributions estimated parameters. When the forecasting model admits only normally-distributed outcomes, the authors find small, acyclical changes in uncertainty. But when agents can also estimate parameters that regulate skewness, uncertainty fluctuations become large and counter-cyclical. The reason is that small changes in estimated skewness whip around probabilities of unobserved tail events (black swans). The resulting forecasts resemble those of professional forecasters. The authors' uncertainty estimates reveal that revisions in parameter estimates, especially those that affect the risk of a black swan, explain most of the shocks to uncertainty.

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Gill Segal and Ivan Shaliastovich, University of Pennsylvania, and Amir Yaron, University of Pennsylvania and NBER

Good and Bad Uncertainty: Macroeconomic and Financial Market Implications

Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, Segal, Shaliastovich, and Yaron decompose aggregate uncertainty into 'good' and 'bad' volatility components, associated with positive and negative innovations to macroeconomic growth. The authors document that in line with their theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline in economic growth and depresses asset prices. Furthermore, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk.

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George Alessandria, Federal Reserve Bank of Philadelphia; Horag Choi, Monash University; Joseph Kaboski, University of Notre Dame and NBER; and Virgiliu Midrigan, New York University and NBER

Microeconomic Uncertainty, International Trade, and Aggregate Fluctuations

The extent and direction of causation between micro volatility and business cycles is debated. Alessandria, Choi, Kaboski, and Midrigan examine, empirically and theoretically, the source and effects of fluctuations in the dispersion of producer level sales and production over the business cycle. On the theoretical side, the authors study the effect of exogenous first and second moment shocks to producer level productivity in a two-country DSGE model with heterogenous producers and endogenous export participation. First moment shocks cause endogenous fluctuations in producer level dispersion through a channel of international reallocation, while second moment shocks lead to increases in exports relative to GDP in recessions. Empirically, the authors find evidence that international reallocation channel is indeed important for understanding cross-industry variation in cyclical patterns of measured dispersion.

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Marina Azzimonti, Federal Reserve Bank of Philadelphia

Partisan Conflict

American politics have become extremely polarized in recent decades. This deep political divide has caused significant government dysfunction. Political divisions make the timing, size, and composition of government policy less predictable. According to existing theories, an increase in the degree of economic policy uncertainty results in a decline in economic activity. This occurs because businesses and households may be induced to delay decisions that involve high reversibility costs. In addition, disagreement between policymakers may result in stalemate that adversely affects the optimal implementation of policy reforms, and may result in excessive debt accumulation. Testing these theories has been challenging given the low frequency at which existing measures have been computed. In this paper, Azzimonti provides a novel high-frequency indicator of partisan conflict. The index, constructed between 1891 and 2013, uses a search-based approach that measures the frequency of newspaper articles reporting lawmakers' disagreement about policy. The author shows that the trend in partisan conflict is related to polarization and income inequality. Its short-run fluctuations are highly correlated with elections, but unrelated to recessions. The lower-than-average values observed during wars suggest a "rally around the flag" effect. The author use the index to study the effect of an increase in partisan conflict, equivalent to the one observed since the Great Recession, on business cycles. Using a simple VAR, the author finds that an innovation to partisan conflict increases government deficits and significantly discourages investment, output, and employment. Moreover, these declines are persistent, which may help explain the slow recovery observed since the 2007 recession ended.

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John Campbell and Luis Viceira, Harvard University and NBER, and Carolin Pflueger, University of British Columbia

Monetary Policy Drivers of Bond and Equity Risks (NBER Working Paper 20070)

The exposure of US Treasury bonds to the stock market has moved considerably over time. While it was slightly positive on average in the period 1960-2011, it was unusually high in the 1980s and negative in the 2000s, a period during which Treasury bonds enabled investors to hedge macroeconomic risks. Campbell, Pflueger, and Viceira explore the effects of monetary policy parameters and macroeconomic shocks on nominal bond risks, using a New Keynesian model with habit formation and discrete regime shifts in 1979 and 1997. The increase in bond risks after 1979 is attributed primarily to a shift in monetary policy towards a more anti-inflationary stance, while the more recent decrease in bond risks after 1997 is attributed primarily to an increase in the persistence of monetary policy interacting with continued shocks to the central bank's inflation target. Endogenous responses of bond risk premia amplify these effects of monetary policy on bond risks.

Jesus Fernandez-Villaverde, University of Pennsylvania and NBER; Pablo Guerrón-Quintana, Federal Reserve Bank of Philadelphia; Keith Kuester, University of Bonn; and Juan Rubio-Ramírez, Duke University

Fiscal Volatility Shocks and Economic Activity (NBER Working Paper 17317)

Fernaandez-Villaverde, Guerrón-Quintana, Kuester, and Rubio-Ramírez study the effects of changes in uncertainty about future fiscal policy on aggregate economic activity. First, the authors estimate tax and spending processes for the U.S. that allow for time-varying volatility. They uncover strong evidence of the importance of this time-varying volatility in accounting for the dynamics of tax and spending data. They then feed these processes into an otherwise standard New Keynesian business cycle model fitted to the U.S. economy. The authors find that fiscal volatility shocks can have a sizable adverse effect on economic activity and inflation, in particular, when the economy is at the zero lower bound of the nominal interest rate. An endogenous increase in markups is a key mechanism in the transmission of fiscal volatility shocks.

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Dario Caldara, Cristina Fuentes-Albero, and Egon Zakrajsek, Federal Reserve Board, and Simon Gilchrist, Boston University and NBER

The Macroeconomic Impact of Financial and Uncertainty Shocks

The extraordinary events surrounding the "Great Recession" have cast a considerable doubt on the traditional sources of macroeconomic disturbances. In their place, economists have singled out financial and uncertainty shocks as important drivers of economic fluctuations. Distinguishing between these two types of shocks, however, is difficult because increases in uncertainty are frequently associated with a widening of credit spreads, an indication of a tightening in financial conditions. Caldara, Fuentes-Albero, Gilchrist, and Zakrajsek use the penalty function approach to jointly identify shocks behind changes in financial conditions and economic uncertainty and to trace out the impact of these two types of shocks on the economy. Importantly, the identifying assumptions do not rule out a contemporaneous response of financial conditions to uncertainty shocks or vice versa. The authors' results indicate that (1) financial shocks have a significant adverse effect on economic outcomes and that such shocks were an important source of cyclical fluctuations since the mid-1980; (2) uncertainty shocks have a significant macroeconomic impact in situations where they elicit a tightening of financial conditions; and (3) the rise in uncertainty in response to a financial shock suggests that swings in uncertainty are influenced importantly by changes in financial conditions. These findings are robust across a wide range of uncertainty indicators used in the literature.

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Francois Gourio, Federal Reserve Bank of Chicago and NBER; Michael Siemer, Federal Reserve Board; and Adrien Verdelhan, MIT and NBER

Uncertainty Betas and International Capital Flows

Gourio, Siemer, and Verdelhan propose a novel measure of country risk, the uncertainty beta, which is obtained by regressing on a rolling window the realized volatility of a country's stock market return on the world stock market volatility. The authors find a shock to global volatility reduces the capital inflows from foreigners in the countries with the highest uncertainty betas. At the same time, domestic residents of highest beta countries sell more foreign assets, and thus the effect on net capital flows is subdued. Investment and GDP fall significantly more in these countries than in low uncertainty beta countries. These differences across countries are statistically significant in a large panel of 35 countries over the last 40 years. A simple portfolio choice model illustrates one potential channel that may explain the empirical findings: in the model, a higher volatility beta proxies for a higher expropriation risk of foreigners.

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George Gao, Cornell University, and Zhaogang Song, Federal Reserve Board

Rare Disaster Concerns Everywhere

Gao and Song show that rare disaster concerns strongly drive cross-sectional return variation both within and across asset classes, including international equity indices, currencies, global government bonds, and commodities. Using a large set of out-of-the-money options on these assets, the authors measure the global financial market's rare disaster concerns under only no-arbitrage conditions. Assets that have low (high) return covariations with such concerns earn high (low) excess returns in the future. Such return patterns are not attributed to effects of global value and momentum, and are robust to various long/short positions of average investors. The authors' results are not explained by consumption and macroeconomic disaster risk, financial market disaster risk, and funding and liquidity constraints of financial intermediaries. The evidence suggests time-varying disaster fear/aversion as a potential venue to reconcile return dynamics across asset classes.

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Pablo Fajgelbaum, University of California, Los Angeles and NBER; Edouard Schaal, New York University; and Mathieu Taschereau-Dumouchel, University of Pennsylvania

Uncertainty Traps (NBER Working Paper 19973)

Fajgelbaum, Schaal, and Taschereau-Dumouchel develop a theory of endogenous uncertainty and business cycles in which short-lived shocks can generate long-lasting recessions. In the model, higher uncertainty about fundamentals discourages investment. Since agents learn from the actions of others, information flows slowly in times of low activity and uncertainty remains high, further discouraging investment. The unique equilibrium of this economy displays uncertainty traps: self-reinforcing episodes of high uncertainty and low activity. While the economy recovers quickly after small shocks, large temporary shocks may have nearly permanent effects on the level of activity. The economy is subject to an information externality but uncertainty traps remain even in the efficient allocation. The authors extend their framework to include additional features of standard business cycle models and show, in that context, that uncertainty traps can substantially worsen recessions and increase their duration, even under optimal policy interventions.

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Bryan Kelly, University of Chicago and NBER; Hanno Lustig, University of California, Los Angeles and NBER; and Stijn Van Nieuwerburgh, New York University and NBER

Firm Volatility in Granular Networks (NBER Working Paper 19466)

Kelly, Lustig, and Van Nieuwerburgh propose a network model of firm volatility in which the customers' growth rate shocks influence the growth rates of their suppliers, larger suppliers have more customers, and the strength of a customer-supplier link depends on the size of the customer firm. Even though all shocks are i.i.d., the network model produces firm-level volatility and size distribution dynamics that are consistent with the data. In the cross section, larger firms and firms with less concentrated customer networks display lower volatility. Over time, the volatilities of all firms co-move strongly, and their common factor is concentration of the economy-wide firm size distribution. Network effects are essential to explaining the joint evolution of the empirical firm size and firm volatility distributions.