67 Pages Posted: 2 Dec 2019 Last revised: 22 Jun 2020
Date Written: March 18, 2020
This paper investigates the transmission of uncertainty about the state of government finances on economic activity. I first employ a data-rich approach to extract a novel proxy that captures uncertainty surrounding the public finances of the Spanish economy, to which I refer as sovereign uncertainty, and demonstrate its agreement with historical narrative evidence. The estimated measure exhibits autonomous fluctuations from macro-financial and economic policy uncertainties. Next, I rely on Bayesian vector autoregression methods to analyze the behavior of the identified sovereign uncertainty shocks and detect the presence of significant and persistent negative effects in the financial and macroeconomic sectors. These results are robust across different identification strategies: recursive and pure sign restrictions. Finally, I rationalize these findings in a New Keynesian dynamic stochastic general equilibrium model with recursive preferences and financial intermediaries. This theoretical framework can capture entire empirical slowdowns in economic aggregates only if the monetary authority does not react enough in the aftermath of a sovereign uncertainty shock. However, a substantial matching is still obtained in the presence of a larger response by the central bank. The model also emphasizes the importance of financial frictions in transmitting the effects of sovereign uncertainty shocks and highlights the minor role played by nominal rigidities.
Keywords: Sovereign Uncertainty Index, Government Finances, Economic Activity, Bayesian VARs, Non-Linear DSGE Models
JEL Classification: C32, E32, E44, E60
Suggested Citation: Suggested Citation