Sovereign Uncertainty

This paper investigates the impact and the transmission of uncertainty regarding the future path of government finances on economic activity. I first employ a data-rich approach to extract a novel proxy that captures uncertainty surrounding public finances, which I refer to as sovereign uncertainty, and demonstrate that the estimated measure exhibits distinct fluctuations from macro-financial and economic policy uncertainty indices. Next, I analyze the behavior of sovereign uncertainty shocks and detect the presence of significant and long-lasting negative effects in the financial and macroeconomic sectors using state-ofthe-art identification strategies, within the context of a Bayesian vector autoregression framework. I show that a shock to sovereign uncertainty differs from a macro-financial uncertainty shock — while the former dampens the economy in the medium-run and points to deflationary dynamics, the latter displays a short-lived response in real activity and generates inflationary pressures. Finally, I study the role of sovereign uncertainty in a New Keynesian dynamic stochastic general equilibrium model augmented with recursive preferences and financial intermediaries. I find that a sovereign uncertainty shock in the model is able to capture the empirical slowdowns in economic aggregates if there is lack of reaction by the monetary authority in the aftermath of the shock. The model also emphasizes the importance of financial frictions in transmitting the effects of sovereign uncertainty shocks and highlights the minor role played by nominal rigidities.