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Balke et al. (2017)'s model integrates financial frictions-arising from asymmetric information and costly monitoring-and time-varying uncertainty into a medium-scale Dynamic New Keynesian model. The model includes monetary policy uncertainty, financial risks (micro-uncertainty), and aggregate macro-uncertainty in stochastic volatility form. In this paper, we provide the key derivations of the model as well as detailed information on the simulation and estimation approach employed. We use this modeling framework to thoroughly explore how uncertainty propagates and its interplay with financial frictions. We also investigate further how uncertainty affects the propagation of first-moment shocks (TFP and monetary policy shocks) and second-moment shocks with first-order effects (micro-uncertainty).

We examine the interaction of uncertainty and credit frictions in a New Keynesian framework. To do so, uncertainty is modeled as time-varying stochastic volatility-the product of monetary policy uncertainty, financial risk (micro-uncertainty), and macrouncertainty. The model is solved using a pruned third-order approximation and estimated by the Simulated Method of Moments. We find that: 1) Micro-uncertainty aggravates the information asymmetry between lenders and borrowers, worsens credit conditions, and has first-order effects on real economic activity. 2) When credit conditions are poor, as indicated by elevated credit spreads, additional micro-uncertainty shocks produce even larger real effects. 3) Poor credit conditions notably affect the transmission mechanism of monetary policy amplifying the real effects of monetary shocks while mitigating the economic boost from TFP shocks. 4) While macro-uncertainty and policy uncertainty exert relatively little direct impact on aggregate economic activity, policy uncertainty accounts for around 40% of the business cycle volatility by affecting the size of monetary policy shocks in the presence of nominal rigidities.

Balke et al. (2017)'s model integrates financial frictions-arising from asymmetric information and costly monitoring-and time-varying uncertainty into a medium-scale Dynamic New Keynesian model. The model includes monetary policy uncertainty, financial risks (micro uncertainty), and aggregate macro-uncertainty in stochastic volatility form. In this paper, we provide the key derivations of the model as well as detailed information on our simulation and estimation approach. We use this framework to identify how uncertainty propagates and its interplay with financial frictions. We also investigate how uncertainty affects the propagation of other shocks (in particular, the propagation of TFP and monetary policy shocks).

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