Non-Linear Effects of Uncertainty

Recent empirical studies suggest that the negative effects of uncertainty shocks are stronger in recessions than during booms. In this study, I provide a theoretical mechanism that can explain this empirical observation. I start from the argument that the effect of uncertainty on investment depends on the degree of irreversibility. I then show that the degree of irreversibility increases during recessionary times. Incorporating this fact in a DSGE model with heterogeneous firms and uncertainty shows that time-varying irreversibility is able to produce state-dependent reactions of macroeconomic aggregates to an uncertainty shock that are similar to those observed in the data