Understanding the Aggregate Effects of Credit Frictions and Uncertainty
50 Pages Posted: 15 Jun 2017
Date Written: June 12, 2017
This paper integrates a financial accelerator mechanism à la Bernanke et al. (1999) and time-varying uncertainty into a Dynamic New Keynesian model. We examine the extent to which uncertainty and credit conditions interact with one another. The idea is that uncertainty aggravates the information asymmetry between lenders and borrowers, and worsens credit conditions. Already poor credit conditions amplify the effect of shocks (to both the mean and variance) on the aggregate economy. In our model, uncertainty modelled as time-varying stochastic volatility emerges from monetary policy (policy uncertainty), financial risks (micro-uncertainty), and the aggregate state of the economy (macro-uncertainty). Using a third order approximation, we find that micro-uncertainty has first order effects on economic activity through its direct impact on credit conditions. We also find that if credit conditions (as measured by the endogenous risk spread) are already poor, then additional micro-uncertainty shocks have even larger real effects. In turn, shocks to aggregate uncertainty (macro- and policy-uncertainty) have relatively small direct effects on aggregate economic activity.
Keywords: Stochastic Volatility, Uncertainty, Financial Accelerator, Perturbation Methods
JEL Classification: E32, E44, D8, C32
Suggested Citation: Suggested Citation