The level effect and volatility effect of uncertainty shocks in China

Abstract

Previous studies have assumed that the volatility of exogenous shocks is constant, which can only measure the level effects of uncertain shocks. This article introduces the time-varying volatility model into a Dynamic Stochastic General Equilibrium (D.S.G.E.) model and uses the third-order perturbation method to identify and decompose the level and volatility effects of uncertainty shocks. Based on the results of empirical research in China, the effect of volatility shocks is different from that of level shocks: the effect of level shocks is direct and positive, and its impact is larger, while the effect of volatility shocks is indirect and negative, and its impact is smaller. This article also finds that the impact of uncertainty shocks will lead to economic stagnation, inflation, and the stagflation effect.