Abstract
AbstractThis article studies the effects of uncertainty shocks on economic activity, focusing on inflation. Using a vector autoregression, I show that increased uncertainty has negative demand effects, reducing GDP and prices. I then consider standard New Keynesian models with Rotemberg‐type and Calvo‐type price rigidities. Despite the belief that the two schemes are equivalent, I show that they generate different dynamics in response to uncertainty shocks. In the Rotemberg model, uncertainty shocks decrease output and inflation, in line with the empirical results. By contrast, in the Calvo model, uncertainty shocks decrease output but raise inflation because of firms' precautionary pricing motive.
Highlights
Uncertainty has received substantial attention in the wake of the Great Recession and the subsequent slow recovery
In a New Keynesian framework, increased uncertainty leads to a decrease in aggregate demand because of precautionary saving motives and time-varying markups
I quantitatively investigate the effects of uncertainty shocks on macroeconomic variables in the Rotemberg and Calvo models
Summary
Uncertainty has received substantial attention in the wake of the Great Recession and the subsequent slow recovery. This article contributes to the literature that studies the propagation of uncertainty shocks in New Keynesian models This is the first article that highlights the different responses to uncertainty shocks in the Rotemberg and Calvo models. Born and Pfeifer (2014) and Mumtaz and Theodoridis (2015), which adopt Calvo pricing, argue that uncertainty shocks result in a decrease in output but an increase in inflation, that is, negative supply shocks. Fernandez-Villaverde et al (2015) study an inflationary effect of uncertainty shocks in a Rotemberg-type New Keynesian model This result is obtained because, in contrast to the above-mentioned literature, their price adjustment cost directly affects firms’ marginal costs.
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