The Variety Effect in Times of Uncertainty

with Francesco Saverio Gaudio (University of Rome)

Abstract: 

This paper shows that the variety effect, captured through monopolistic competition and increasing returns to specialization, acts as an amplification mechanism in the transmission of macroeconomic uncertainty shocks. By generating endogenous fluctuations in aggregate productivity through changes in the range of available products, due to firm entry and exit, the variety effect reinforces the risk channels through which uncertainty shocks propagate to the economy. The estimated intensity of the variety effect implies sizable productivity fluctuations, which shape the joint dynamics of households’ marginal utility, firms’ profits, and relative prices. When the equity risk-premium channel dominates, the variety effect implies deeper uncertainty-driven recessions, as discouraged investment in the stock market and the consequent fall in product creation leads to a drop in endogenous productivity.