Uncertainty and the Economy: The Evolving Distributions of Aggregate Supply and Demand Shocks

We estimate the time-varying distribution of aggregate supply (AS) and aggregate demand (AD) shocks defined in the Keynesian tradition. In modeling the time variation in higher order moments, we distinguish between traditional Gaussian uncertainty and uncertainty, associated with negative skewness. The Great Moderation is driven by decreases in Gaussian (not bad) uncertainty. The increased role of bad uncertainty implies that the conditional skewness of GDP growth and inflation and the correlation between level and uncertainty shocks in macro data are more negative. Bad uncertainty for aggregate supply is the main factor explaining why total uncertainty negatively predicts economic activity.