Uncertainty and Monetary Policy During Extreme Events

76 Pages Posted: 3 Sep 2020

See all articles by Giovanni Pellegrino

Giovanni Pellegrino

Aarhus University

Efrem Castelnuovo

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

Giovanni Caggiano

Department of Economics, Monash University; University of Padova

Multiple version iconThere are 2 versions of this paper

Date Written: September 2, 2020


How damaging are uncertainty shocks during extreme events such as the great recession and the Covid-19 outbreak? Can monetary policy limit output losses in such situations? We use a nonlinear VAR framework to document the large response of real activity to a financial uncertainty shock during the great recession. We replicate this evidence with an estimated DSGE framework featuring a concept of uncertainty comparable to that in our VAR. We employ the DSGE model to quantify the impact on real activity of an uncertainty shock under different Taylor rules estimated with normal times vs. great recession data (the latter associated with a stronger response to output). We find that the uncertainty shock-induced output loss experienced during the 2007-09 recession could have been twice as large if policymakers had not responded aggressively to the abrupt drop in output in 2008Q3. Finally, we use our estimated DSGE framework to simulate different paths of uncertainty associated to different hypothesis on the evolution of the coronavirus pandemic. We find that: i) Covid-19-induced uncertainty could lead to an output loss twice as large as that of the great recession; ii) aggressive monetary policy moves could reduce such loss by about 50%.

Keywords: Uncertainty shock, nonlinear IVAR, nonlinear DSGE framework, minimum-distance estimation, great recession, Covid-19

JEL Classification: C22, E32, E52

Suggested Citation

Pellegrino, Giovanni and Castelnuovo, Efrem and Caggiano, Giovanni, Uncertainty and Monetary Policy During Extreme Events (September 2, 2020). CAMA Working Paper No. 80/2020, Available at SSRN: https://ssrn.com/abstract=3684962 or http://dx.doi.org/10.2139/ssrn.3684962

Giovanni Pellegrino

Aarhus University ( email )

Nordre Ringgade 1
DK-8000 Aarhus C, 8000

Efrem Castelnuovo (Contact Author)

University of Melbourne - Department of Economics ( email )

Melbourne, 3010

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

University of Padova - Department of Economics

via Del Santo 33
Padova, 35123

Giovanni Caggiano

Department of Economics, Monash University ( email )

900 Dandenong Road
Caulfield East, Victoria 3145

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

University of Padova ( email )

Via 8 Febbraio, 2
Padova, Vicenza 35122

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