Effects of financial constraints and policy uncertainty on the economy with shifting trend inflation

Abstract

The primary purpose of this paper is to investigate macroeconomic, financial and welfare effects of financial constraints and policy uncertainty on the economy featuring shifting trend inflation. By developing a New Keynesian model incorporating trend inflation into staggered prices and staggered credit channel, we indicate three important findings. First, we report negligible welfare consequences of financial shocks, whereas policy uncertainty shocks dampen the economic welfare considerably. More importantly, financial frictions are a channel through which policy uncertainty stuns the economy more remarkably. Second, the welfare consequences and business cycles effects of shocks are greater in the high-trend-inflation economy, while the costs of exogenous variations in trend inflation are larger if there is policy uncertainty. Third, among staggered prices and staggered credit, the later plays a more vital role in transmitting adverse effects of shocks to trend inflation into the economy.