Economics Seminar - "Risk, Uncertainty, and Financial Frictions"

This paper studies the role of nancial shocks and uncertainty in causing business cycle fluctuations using a New Keynesian style model. The model features financial frictions, incorporated through a financial accelerator mechanism, and stochastic volatility, which allows the standard deviation of exogenous shocks to change over time. The nonlinear model is estimated using Bayesian techniques and a particle filter. The estimated model is then used to study the impact that financial and uncertainty shocks have on the economy. I find that uncertainty shocks can have a signicant impact and are important for explaining business cycles. While most uncertainty shocks have smaller impacts than the traditional shocks commonly found in DSGE models, increases in uncertainty surrounding future intertemporal tradeos and wealth can lead to a sizable drop in consumption, investment, and output. I also find that wealth shocks reduce investment and output, showing the importance of nancial frictions. The impacts of these shocks are larger than the "risk shocks," which make borrowers more risky and are modeled after those found in Christiano, Motto, and Rostagno (2014). Using a variance decomposition study, I find that stochastic volatility, especially stochastic volatility associated with wealth, intratemporal, and intertemporal shocks, is important in explaining fluctuations in output, inflation, investment, consumption, and credit spreads. These results suggest that uncertainty shocks associated with entrepreneurial wealth and household behavior are important drivers of the business cycle, but uncertainty is less important than traditional shocks typically found in DSGE models.