Financial Disruptions and Heightened Uncertainty: A Case for Timely Policy Action

Abstract

We examine whether the response of the euro area economy to uncertainty shocks depends on the state of financial conditions. We find strong evidence that uncertainty shocks have much more powerful effects on key macroeconomic variables in episodes marked by financial distress than in normal times. We document that the recovery of economic activity is state-dependent following an adverse uncertainty shock. More precisely, it is gradual in normal times, but displays a more accelerated rebound when the shock hits during financial distress. These findings are based on a non-linear data-driven model that accounts for regime switching and time-varying volatility. Finally, from a policy perspective, we argue that whether financial markets are calm or distressed matters when it comes to the appropriate policy responses to uncertainty shocks.