Description:
Using a Markov-switching VAR, we show that the effects of uncertainty shocks on output are four times higher in a regime of economic distress than in a tranquil regime. We then provide a structural interpretation of these facts. To do so, we develop a business cycle model in which agents are aware of the possibility of regime changes when forming expectations. The model is estimated using a Bayesian minimum distance estimator that minimizes, over the set of structural parameters, the distance between the regime-switching VAR-based impulse response functions and those implied by the model. Our results point to worsening credit-market conditions that amplify shocks during distress periods. Finally, we show that the expectation effect of regime switching in financial conditions is an important component of the financial accelerator mechanism. If agents are more pessimistic about future financial conditions, then the output effects of shocks are amplified.