Uncertainty Shocks, Mean-Variance Frontiers, and Business Cycles∗

This paper constructs a model economy to explain how uncertainty shocks can cause business cycle fluctuations. In the model, during times of high uncertainty, the representative agent, due to risk aversion motives, moves resources from a high risk/high return production process to a low risk/low return production process. High uncertainty thus causes the firm level technology frontier to endogenously move inward and generate a recession. The uncertainty shock induced endogenous movements in the technology frontier closely mimic movements caused by conventional first moment technology shocks. This result highlights the possibility of mis-identification of uncertainty shocks in the data as first moment shocks. In addition, endogenous movements of the technology frontier in the model act to dampen the resulting volatility of macroeconomic variables thereby pointing to a systematic bias that can occur if the magnitude of uncertainty shocks is naively measured as the variance of the error term of the AR(1) total factor productivity process in data. J.E.L. Classification: E3.