Real Activity and Uncertainty Shocks: The Long and the Short of It

We extend a state-of-the-art DSGE model to include short- and long-term uncertainty shocks that differ in terms of persistence. Considering the two shocks is essential for capturing the imperfect empirical relationship between short- and long-term financial uncertainty as proxied by the VIX. Leveraging the model’s implications about the VIX term structure, we suggest a theory-informed, nonrecursive identification strategy to separately identify the macroeconomic effects of the two shocks in a structural VAR. In line with the DSGE model, long-term uncertainty shocks have stronger and more persistent real effects than short-term shocks. Moreover, they explain a substantial fraction of the forecast error variance in unemployment and the policy rate at horizons greater than two years. In a supplementary analysis of uncertainty news shocks, we show that news about higher uncertainty in the future is recessionary.