Abstract

The Great Recession has motivated economists to investigate financial uncertainty shocks as potentially important drivers of economic fluctuations. However, not all of the factors affecting financial uncertainty could cause economic downturns. In this paper, we find non-synchronized movements of two new measures of financial market uncertainty — good and bad volatility — which are based on the maximum and minimum stock prices within a month. Good (bad) volatility is associated with better (worse) expectations about the future economic situation and clearly signals acceleration (deceleration) in economic activity. We further investigate the importance of financial uncertainty implied by the new measures. The VAR results indicate that (1) output, employment, and stock price plummet rapidly in response to a bad volatility shock, while their responses to a good volatility shock are modest, and (2) bad volatility shocks explain the bulk of economic activity and stock price fluctuations in the medium run. These results suggest that bad volatility shocks are harmful to the economy and drive business cycle fluctuations. Distinguishing between these two types of financial uncertainty is crucial in understanding the roles that financial uncertainty plays in economic fluctuations.

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