Working Paper: NBER ID: w22058
Authors: Dario Caldara; Cristina Fuentes-Albero; Simon Gilchrist; Egon Zakrajsek
Abstract: The extraordinary events surrounding the Great Recession have cast a considerable doubt on the traditional sources of macroeconomic instability. In their place, economists have singled out financial and uncertainty shocks as potentially important drivers of economic fluctuations. Empirically distinguishing between these two types of shocks, however, is difficult because increases in economic uncertainty are strongly associated with a widening of credit spreads, an indication of a tightening in financial conditions. This paper uses the penalty function approach within the SVAR framework to examine the interaction between financial conditions and economic uncertainty and to trace out the impact of these two types of shocks on the economy. The results indicate that (1) financial shocks have a significant adverse effect on economic outcomes and that such shocks were an important source of cyclical fluctuations since the mid-1980s; (2) uncertainty shocks, especially those implied by uncertainty proxies that do not rely on financial asset prices, are also an important source of macroeconomic disturbances; and (3) uncertainty shocks have an especially negative economic impact in situations where they elicit a concomitant tightening of financial conditions. Evidence suggests that the Great Recession was likely an acute manifestation of the toxic interaction between uncertainty and financial shocks.
Keywords: Macroeconomic shocks; Financial conditions; Uncertainty; Business cycles
JEL Codes: E32; E37; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial shocks (F65) | Economic outcomes (F69) |
| Financial shocks (F65) | Financial conditions (E66) |
| Financial conditions (E66) | Economic activity (E29) |
| Uncertainty shocks (D89) | Economic uncertainty (D89) |
| Economic uncertainty (D89) | Financial conditions (E66) |
| Uncertainty shocks (D89) | Economic outcomes (F69) |
| Interaction of uncertainty shocks and financial shocks (E44) | Economic activity (E29) |