Risk and Uncertainty: The Role of Financial Frictions

This paper studies the economic impact of financial and uncertainty shocks using an estimated, nonlinear New Keynesian model with financial frictions. While uncertainty shocks have smaller impacts than most first-order shocks, increases in uncertainty surrounding labor supply, capital production and wealth lead to a sizable drop in consumption and investment. Financial frictions play an important role in amplifying the uncertainty shocks. As macroeconomic uncertainty increases, the performance of loans also becomes less certain. This causes financial conditions to tighten and the credit spread to increase, which results in a decline in investment. The filtered states of the model show that the uncertainty of labor supply, capital production and wealth shocks increased in the United States during the 2007–2009 financial crisis. Counterfactual results show that these increases in volatility and uncertainty, especially for the wealth shock, played key roles in causing the Great Recession, accounting for most of the decline in investment and the tightening of credit conditions.