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Uncertainty in a model with credit frictions

Listed author(s):
  • Cesa-Bianchi, Ambrogio

    ()

    (Bank of England)

  • Fernandez-Corugedo, Emilio

    (Bank of England)

This paper investigates the relationship between uncertainty and economic activity in a DSGE model with sticky prices and credit frictions. We analyse the effect of a mean preserving shock to the variance of aggregate total factor productivity (macro uncertainty) and we compare it to the effect of a mean preserving shock to the dispersion of entrepreneurs' idiosyncratic productivity (micro uncertainty). We find that micro uncertainty has a larger impact on economic activity. While macro uncertainty is transmitted through precautionary savings, micro uncertainty primarily acts through the cost of external debt and capital demand and, therefore, it is greatly magnified by the credit friction. Our findings suggest that uncertainty shocks can generate sizable impact on economic activity only when transmitted through a credit channel.

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File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2014/wp496.pdf
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Paper provided by Bank of England in its series Bank of England working papers with number 496.

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Length: 49 pages
Date of creation: 17 Apr 2014
Handle: RePEc:boe:boeewp:0496
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