Financial uncertainty and real activity: The good, the bad, and the ugly

32 Pages Posted: 10 Jul 2020

See all articles by Giovanni Caggiano

Giovanni Caggiano

Department of Economics, Monash University; University of Padova

Efrem Castelnuovo

University of Melbourne - Department of Economics; University of Padova - Department of Economics

Richard Kima

Monash University - Department of Economics

Silvia Delrio

Bank of Italy

Multiple version iconThere are 2 versions of this paper

Date Written: July 10, 2020

Abstract

This paper quantifies the finance uncertainty multiplier (i.e., the magnifying effect of the real impact of uncertainty shocks due to financial frictions) by relying on two historical events related to the US economy, i.e., the large jump in financial uncertainty occurred in October 1987 (which was not accompanied by a deterioration of the credit supply conditions), and the comparable jump in financial uncertainty in September 2008 (which went hand-in-hand with an increase in financial stress). Working with a VAR framework and a set-identification strategy which focuses on - but it is not limited to - restrictions related to these two dates, we estimate the finance uncertainty multiplier to be equal to 2, i.e., credit supply disruptions are found to double the negative output response to an uncertainty shock. We then employ our model to estimate the overall economic cost of the COVID-19-induced uncertainty shock under different scenarios. Our results point to the possibility of a cumulative yearly loss of industrial production as large as 31% if credit supply gets disrupted. Liquidity interventions that keep credit conditions as healthy as they were before the COVID-19 uncertainty shock are found to substantially reduce such loss.

Keywords: uncertainty shocks, finance-uncertainty multiplier, set-identification, VAR, financial frictions, COVID-19

JEL Classification: C32, E32

Suggested Citation

Caggiano, Giovanni and Castelnuovo, Efrem and Kima, Richard and Delrio, Silvia, Financial uncertainty and real activity: The good, the bad, and the ugly (July 10, 2020). CAMA Working Paper No. 67/2020, Available at SSRN: https://ssrn.com/abstract=3647652 or http://dx.doi.org/10.2139/ssrn.3647652

Giovanni Caggiano

Department of Economics, Monash University ( email )

900 Dandenong Road
Caulfield East, Victoria 3145
Australia

HOME PAGE: http://https://sites.google.com/site/giovannicaggiano72/CV/home

University of Padova ( email )

Via 8 Febbraio, 2
Padova, Vicenza 35122
Italy

Efrem Castelnuovo (Contact Author)

University of Melbourne - Department of Economics ( email )

Melbourne, 3010
Australia

HOME PAGE: http://https://sites.google.com/site/efremcastelnuovo/home

University of Padova - Department of Economics

via Del Santo 33
Padova, 35123
Italy

Richard Kima

Monash University - Department of Economics ( email )

Australia

Silvia Delrio

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

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