The macroeconomic impact of financial and uncertainty shocks

Abstract

The extraordinary events surrounding the Great Recession have cast a considerable doubt on the traditional sources of macroeconomic instability. In their place, economists have singled out financial and uncertainty shocks as potentially important drivers of economic fluctuations. Empirically distinguishing between these two types of shocks, however, is difficult because increases in economic uncertainty are strongly associated with a widening of credit spreads, an indication of a tightening in financial conditions. This paper uses the penalty function approach within the SVAR framework to examine the interaction between financial conditions and economic uncertainty and to trace out the impact of these two types of shocks on the economy. The results indicate that (1) financial shocks have a significant adverse effect on economic outcomes and that such shocks were an important source of cyclical fluctuations since the mid-1980; (2) uncertainty shocks, especially those implied by uncertainty proxies that do not rely on financial asset prices, are also an important source of macroeconomic disturbances; and (3) uncertainty shocks have an especially negative economic impact in situations where they elicit a concomitant tightening of financial conditions. Evidence suggests that the Great Recession was likely an acute manifestation of the toxic interaction between uncertainty and financial shocks.JEL Classification: E32, E37, E44

Financial Stress Regimes and the Macroeconomy

“…We also find that exogenous increases in the financial conditions factor have not only large negative effects on economic activity as in Caldara et al. (), but also amplification effects on inflation responses and the variance of financial shocks.…”

Uncertainty across volatility regimes

“…3 Ludvigson et al (2018a) propose a novel set identification strategy in a time-invariant framework that allows the joint identification of uncertainty and real activity shocks, without imposing any restrictions on the contemporaneous relations (see also Ludvigson, Ma, & Ng, 2018b). This result lines up with Ng and Wright's (2013) argument that financial factors have played a crucial role in driving the US business cycle after the mid-1980s, and is consistent with Caldara, Fuentes-Albero, Gilchrist, and Zakrajšek (2016) and Caldara and Scotti (2018). The first is what they label "event constraints," which require that the identified financial uncertainty shocks must be large enough during two major financial disruptions-for example, the 1987 stock market crash and the 2007-09 financial crisis.…”

International Effects of Euro Area Versus U.S. Policy Uncertainty: A Favar Approach

“…Finally, as shown by Caldara et al (2016), shocks to uncertainty have an especially large macroeconomic effect if they signal a worsening of financial conditions. Their robust finding that uncertainty increases immediately as a reaction to an adverse financial shock (which is corroborated by Belke, Dubova, and Osowski 2017 in the context of Brexit) makes it possible that changes in uncertainty are driven by fluctuations in financial conditions.…”