Abstract
We show that to capture the empirical effects of uncertainty on the unemployment rate, it is crucial to study the interactions between search frictions and nominal rigidities. Our argument is guided by empirical evidence showing that an increase in un\certainty leads to a large increase in unemployment and a significant decline in inflation, suggesting that uncertainty partly operates via an aggregate demand channel. To understand the mechanism through which uncertainty generates these macroeconomic effects, we incorporate search frictions and nominal rigidities in a DSGE model. We show that an option-value channel that arises from search frictions interacts with a demand channel that arises from nominal rigidities, and such interactions magnify the effects of uncertainty to generate roughly 60 percent of the observed increase in unemployment following an uncertainty shock.
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