Inflation Dynamics and Time-Varying Uncertainty: New Evidence and an Ss Interpretation

I show that the cross-sectional standard deviation of individual price changes in the BLS CPI database is countercyclical and comoves strongly with the frequency of price adjustments. Standard Ss models with only first moment shocks cannot explain these facts. Adding a second moment (`uncertainty') shock improves the model fit significantly. Furthermore, it implies a strongly procyclical sensitivity of aggregate output to nominal shocks, in contrast to standard Ss models, where the sensitivity is acyclical. In the model with second moment shocks the total response of real output to a nominal shock in September of 2008, during a highly uncertain recession, is one quarter of the response in September of 1998, a time of very low uncertainty.