Business Cycle Effects of Firms’ Uncertainty Under Low and High Uncertainty

Abstract

Abstract Non-linearities in the uncertainty-output relationship may help to explain pronounced business cycle fluctuations. We suggest that the level of uncertainty itself influences the reaction of real activity to a surprise increase in uncertainty. We base our analysis on a measure of business uncertainty of firms’ decision makers, which is derived from a large survey panel covering the time-span 1980–2018. To study differences in the response to an increase in uncertainty, we use an interacted VAR model, where coefficients depend on the level of uncertainty, and uncertainty enters as an endogenous variable. Surprise increases in uncertainty have particularly adverse effects when the level of uncertainty is low compared to periods in which firms are already highly uncertain. This non-linear effect occurs during recession and non-recession phases.