Supply Shocks in the Fog: The Role of Endogenous Uncertainty

Abstract

Endogenous uncertainty acts as an aggregate-demand amplification mechanism of supply shocks. Using U.S. data, we first stress that taking into account time-varying macroeconomic uncertainty leads to a significantly stronger recession and less inflationary pressures, in response to a TFP shock. In addition, we show empirically that households' misperception increases during recessions. To rationalize these findings, we build a noisy-information New-Keynesian model where the precision of signals increases with economic activity. Pro-cyclical precision of information gives rise to an amplified precautionary saving behavior. A full-fledged model parametrized by using consumer-based forecast errors generates a demand-like recession of supply shock.