Uncertainty: Macroeconomic Effects and Policy Implications

Melbourne Institute Policy Brief No. 01/17

Date: June 2017


Efrem Castelnuovo
Giovanni Caggiano


Uncertainty is a concept which refers to the inability of consumers, managers and policymakers to perfectly predict future events like a change in labor income, the growth rate of technology, or a variation in the economic environment. Given that consumers and entrepreneurs typically have to make decisions about consumption, labor supply, productive investment and so on in the presence of uncertainty, it is of interest to understand how uncertainty can affect such decisions. This policy brief reviews the most recent literature on this subject by addressing the following questions: Is there a relationship between uncertainty, agents’ decisions, and the business cycle? Is the source of uncertainty domestic or global? How should macroeconomic policies be designed to tackle the negative effects of uncertainty? The findings of this policy brief are: (i) uncertainty is countercyclical (as it tends to peak during recessions) and it appears to be a driver of the business cycle (namely, consumption and investment) in many countries; (ii) investment is found to be more reactive than consumption to heightened uncertainty; (iii) movements in financial markets and economic policy uncertainty indexes are informative about the macroeconomic effects of uncertainty shocks; (iv) the effectiveness of monetary and fiscal policy interventions is negatively affected by uncertainty; (v) conventional macroeconomic policies should be used to stabilize the business cycle and to avoid the build-up of uncertainty; (vi) a clear communication of economic plans by policymakers is crucial to maintaining low uncertainty; and (vii) financial market regulation and macroprudential policies can potentially play an important role in limiting the negative business cycle effects of uncertainty.

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