Solving Asset Pricing Models with Stochastic Volatility

Groot, Oliver De

doi:10.17016/feds.2014.71

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2024

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“…while keeping the level of the variable constant. Recently, de Groot (2019) shows that a fourth order approximation is required for the standard deviation of the stochastic volatility (a.k.a. vol.…”

Section: Literature Reviewmentioning

confidence: 99%

When It Rains It Pours: Cascading Uncertainty Shocks

Diercks¹,

Hsu²,

Tamoni³

2024

Journal of Political Economy

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We empirically document that serial uncertainty shocks are (1) common in the data and (2) have an increasingly stronger impact on the macroeconomy. In other words, a series of bad (positive) uncertainty shocks exacerbates the economic decline significantly. From a theoretical perspective, these findings are puzzling: existing benchmark models do not deliver the observed amplification. We show analytically that a state dependent precautionary motive with respect to uncertainty shocks is required. Our derivations suggest that the state dependent precautionary motive only shows up at fourth order approximations or higher. Fundamentally, in DSGE models solved with perturbations, agents have always possessed a state dependent precautionary motive but typical solution methods were hiding this fact. Future studies need to consider solving the model via fourth (or higher) order perturbation in order to avoid understating the effect of uncertainty shocks that occur in succession.

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Section: Literature Reviewmentioning

confidence: 99%