Are uncertainty shocks aggregate demand shocks?

Abstract

This note considers the Leduc and Liu (JME, 2016) model and studies the e¤ects of their uncertainty shock under di¤erent Taylor-types rules. It shows that both the responses of real and nominal variables highly depend on the Taylor rule considered. Remarkably, in ‡ation reacts positively so that uncertainty shocks look more like supply shocks, once an empirically plausible degree of interest rate smoothness is taken into account. This result is reinforced with less reactive monetary rules. Overall, these rules bring about a less severe recession.

Macroeconomic effects of inflation target uncertainty shocks

“…We show that an inflation target uncertainty shock resembles an aggregate demand shock, a robust qualitative result for different Taylor-type rules. We find no evidence of inflation bias and an IT uncertainty shock is a demand shock regardless the monetary policy reactiveness -a result different than Fasani and Rossi (2018) that show that an uncertainty shock could be either a demand or supply shock depending on the monetary authority interest rate rule. However, the magnitude of real and nominal variables responses depend crucially on the Taylor rule considered.…”

“…In our benchmark model (search frictions and nominal rigidities), we show that an increase in the volatility of the inflation target resembles a contractionary aggregate demand shock -unemployment increases, inflation falls -regardless the monetary authority interest rate rule. The inflation rate does not react positively to an IT volatility shock and, hence, this kind of uncertainty shocks do not generate the inflation bias that lowers recession, for instance, as Fasani and Rossi (2018). We show, however, that the macroeconomic effects of IT uncertainty shocks are quantitatively different and depend crucially on the Taylor-rule type adopted by the monetary authority (i.e,…”

“…In this note we study the macroeconomic effects of uncertainty shocks with an emphasis on the inflation target (IT) stochastic volatility. Building on the literature that analyzes the economic implications of real and nominal uncertainty shocks, in particular, Born and Pfeifer (2014); Leduc and Liu (2016); Fasani and Rossi (2018), we develop a dynamic stochastic general equilibrium (DSGE) model with two distinct features: (i) the IT changes over time and follows an exogenous stochastic process (Ireland, 2007;Cogley et al, 2010) and (ii) the standard deviations of the innovations in the IT are time-varying and follow an autoregressive process. Moreover, our modeling approach is in line with recent evidence on the importance of the time-varying and stochastic volatility of the IT -several studies have drawn attention to the fact that a monetary authority IT might vary over time (see, e.g., Stock and Watson (2007); Ireland (2007); Cogley and Sbordone (2008); Cogley et al (2010)), and others have emphasized the importance of the IT stochastic volatility (e.g, see Stock and Watson (2007); Chan et al (2018)).…”

Uncertainty, Financial Markets, and Monetary Policy over the Last Century

“…Fasani and Rossi (2018) considered the effect of uncertainty shocks under different Taylor rules and found that with a less active Taylor rule,uncertainty shocks look more like aggregate supply shocks rather than demand shocks. Since the U.S. monetary policy was less active during the pre-1985 period than the post-1985 period analyzed in Figure 2A, the inflationary effect of uncertainty shocks and the aggregate supply shock interpretation are also consistent with Fasani and Rossi (2018). Thus, our findings call for caution on the negative demand shock interpretation of uncertainty shocks by Leduc and Liu (2016) and Basu and Bundick (2017).…”

To sign or not to sign? On the response of prices to financial and uncertainty shocks

“…Despite a range of studies reporting a co-movement of prices and output in response to uncertainty shocks (see Leduc and Liu, 2016;Cesa-Bianchi and Fernandez-Corugedo, 2018), Born and Pfeifer (2014), for example, state that firms in a sticky-price environment might find it optimal to raise prices in response to contractionary uncertainty shocks in order to avoid the risk of being stuck with prices that are too low. Furthermore, in a recent study, Fasani and Rossi (2018) provide theoretical results which indicate that, under a plausible specification of monetary policy, uncertainty shocks may drive output and prices in opposite directions.…”