The Variety-Effect Multiplier: On the Transmission of Uncertainty Shocks

The variety effect, arising from monopolistic competition and increasing returns to specialization, acts as an amplification mechanism in the transmission of aggregate, especially uncertainty, shocks. By generating endogenous fluctuations in aggregate productivity through changes in the range of available products, it shapes the joint dynamics of households' marginal utility, firms' profits, and relative prices. Thus, it ultimately reinforces the risk channels through which (uncertainty) shocks propagate to the economy. When the equity risk-premium channel dominates the precautionary-saving one, the variety effect implies deeper uncertainty-driven recessions. However, the relative importance and amplification of these channels depend on the source of perturbation.