The Bad Government: A Source of Uncertainty and Business Fluctuations

Uncertainty represented by volatilities in equity markets has been observed to be time-variable and lead output fluctuations. In the rational expectation framework, uncertainty with this nature needs exogenous variables with time-varying volatilities, but technology, tastes and fiscal and monetary policies do not seem suitable for such variables. The paper contends that supervisions and law enforcement that reduce cheatings in contracts is one of the ultimate sources of uncertainty. The cheating plays an important role for uncertainty since it is the origin of noisy price observations that makes an economy uncertain in the framework of rational expectation approximate equilibria.