Uncertainty in financial markets and business cycles

Can financial uncertainty shocks induce real downturns? To investigate this question theoretically, this paper develops a dynamic stochastic general equilibrium model with two period lived heterogenous agents, monopolistically competitive firms and sticky prices. In the model financial uncertainty is measured by the volatility of stock prices and this volatility results from the stochastic irrational beliefs of nonsophisticated agents about the future performance of the stock. An increase in the stock price volatility decreases aggregate demand and generates a significant contraction in output. The model contributes to the literature by modeling financial market volatility in a general equilibrium framework, establishing its causal impact on real variables, highlighting the mechanisms through which the impact works, and providing estimates of its magnitude.