4 This idea permits us to explain why the decision to wait and see can be optimal and permits us to justify why demand, D, depends negatively on uncertainty, σ. The increase in uncertainty and the fall in demand What is critical about this analysis is that it can be very important from a quantitative point of view. The decision is not marginal. An increase in uncertainty does not result in “some” decrease in spending. An uncertainty shock that is common to all will lead every firm and every consumer to paralyze spending, causing a collapse in demand. The main point is that this fall can be so sharp that one can even have more than one possible equilibrium (Figure 3). This could be the case if households decide to increase their savings significantly, such that low-income families would rather not spend on durable goods. The same could be true if firms decide not to invest. Thus, households and firms would delay  3  For the case of irreversible investment, Dixit and Pindyck (1994) provide a very thorough analysis. A simple example is presented in De Gregorio (2007), chapter 4. 4  Implications like the ones described here can be inferred from the precautionary savings theory. In order to avoid the cost in lost utility of extreme negative events, the consumer chooses to keep some buffer-stock savings. If uncertainty aggravates, for example by increasing the dispersion of future earnings, then precautionary saving will probably increase, which is done by postponing consumption decisions.
Meanwhile, in the United States, the subprime mortgage crisis had already erupted in mid 2007, and by March 2008 an important financial institution, Bear Stearns, had collapsed. An important point of this preamble of the facts of September 2008 is that the string of events I just mentioned had no significant effect on economic expectations, nor did it change the mean of expected growth or increase uncertainty. This, despite the fact that the Bear Stearns bankruptcy was a very significant occurrence for the international financial market. Actually, the volatility of stock markets went up a rung in mid-2007, but was pretty mild if compared with September 2008 (Figure 4). This stock volatility index (VIX), which is normally used as a  4  BIS Review 76/2009  good indicator of uncertainty, 5 shows how it increased several times during the peak of the crisis in September and October of last year. The latest figures show uncertainty declining, although it remains high. Thus, according to market consensus, world growth for 2008-2009 posted no significant changes between March and September of 2008 (Figure 5). The situation in Chile did not differ much (Figure 6). During the whole of 2007, growth projections for 2008 fluctuated around 5 percent, even after the eruption of the housing crisis in the United States. At the time of Bear Stearns’ bankruptcy there had been some adjustment in expected growth for the year, but in September there was even a slight correction upwards. The Bank’s forecasts were similar.