Regime-Dependent Effects of Uncertainty Shocks: A Structural Interpretation

Abstract

Using a Markov-switching VAR, we show that the effects of uncertainty shocks on output are four times higher in a regime of economic distress than in a tranquil regime. We then provide a structural interpretation of these facts. To do so, we develop a business cycle model, in which agents are aware of the possibility of regime changes when forming expectations. The model is estimated using a Bayesian minimum distance estimator that minimizes, over the set of structural parameters, the distance between the regime-switching VAR-based impulse response functions and those implied by the model. Our results point to changes in the degree of financial frictions. We discuss the implications of this structural interpretation and show that the expectation effect of regime switching in financial conditions is an important component of the financial accelerator mechanism. If agents hold pessimistic expectations about future financial conditions, then shocks are amplified and transmitted more rapidly to the economy.