There is substantial evidence that the volatility of the economy is countercyclical. This paper provides new empirical evidence on the relationship between aggregate volatility and the macroeconomy. We aim to test whether that relationship is causal: do increases in uncertainty about the future cause recessions? We measure volatility expectations using market-implied forecasts of future stock return volatility. According to both simple cross-correlations and a wide range of VAR specifications, shocks to realized volatility are contractionary, while shocks to expected volatility in the future have no clear effect on the economy. Furthermore, investors have historically paid large premia to hedge shocks to realized volatility, but the premia associated with shocks to volatility expectations are have not been statistically different from zero. We argue that these facts are inconsistent with models in which increases in expected future volatility cause contractions, but they are in line with the predictions of a simple model in which aggregate technology shocks are negatively skewed. The latter view is also consistent with evidence that equity returns and real activity are negatively skewed.
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|Published - May 8 2016