Expected, Unexpected, Good and Bad Uncertainty

Abstract

By distinguishing between four general notions of uncertainty (good expected, bad-expected, good-unexpected, bad-unexpected) within a common and simple framework, we show that it is bad-unexpected uncertainty shocks that generate a negative reaction of macroeconomic variables (such as investment and consumption), and asset prices. Other notions of uncertainty might produce even positive responses in the macroeconomy. We also show that small uncertainty shocks might have larger impacts on economic activity and financial markets than bigger shocks between one to three years after its realization. We explore the time and magnitude of uncertainty shocks by means of a novel distributed lag nonlinear model. Our results help to elucidate the real and complex nature of uncertainty, which can be both a backward or forward-looking expected or unexpected event, with markedly different consequences for the economy. They have implications for policy making, asset pricing and risk management.