Staff Working Paper No. 730
By Ambrogio Cesa-Bianchi, M Hashem Pesaran and Alessandro Rebucci
Measures of economic uncertainty are countercyclical, but economic theory does not provide definite guidance on the direction of causation between uncertainty and the business cycle. This paper takes a common-factor approach to the analysis of the interaction between uncertainty and economic activity in a multi-country model without a priori restricting the direction of causality at the level of individual countries. Motivated by the observation that cross-country correlations of volatility series are much higher than cross-country correlations of GDP growth series, we set up a multi-country version of the Lucas tree model with time-varying volatility consistent with this stylized fact and use it to identify two common factors, a real and a financial one. We then quantify the absolute and the relative importance of the common shocks as well as country-specific volatility and GDP growth shocks. The paper highlights three main empirical findings. First, it is shown that most of the unconditional correlation between volatility and growth can be accounted for by shocks to the real common factor, which is extracted from world growth in our empirical model and linked to the risk-free rate in the theoretical model and in the data. Second, the share of volatility forecast error variance explained by the real common shock and by country-specific growth shocks amounts to less than 5%. Third, common financial shocks explain about 10% of the growth forecast error variance, but when such shocks occur, their negative impact on growth is large and persistent. In contrast, country-specific volatility shocks account for less than 1%-2% of the forecast error variance decomposition of country-specific growth rates.