Uncertainty Shocks in a Model of Effective Demand: Comment

RePEc Short ID: pri261
ORCID iD: 0000-0003-2876-9615

Richter, Alexander W.; Throckmorton, Nathaniel A.; de Groot, Oliver

doi:10.24149/wp1706

Working Paper

Uncertainty Shocks in a Model of Effective Demand: Comment

Abstract: Basu and Bundick (2017) show a second moment intertemporal preference shock creates meaningful declines in output in a sticky price model with Epstein and Zin (1991) preferences. The result, however, rests on the way they model the shock. If a preference shock is included in Epstein-Zin preferences, the distributional weights on current and future utility must sum to 1, otherwise it creates an asymptote in the response to the shock with unit intertemporal elasticity of substitution. When we change the preferences so the weights sum to 1, the asymptote disappears as well as their main results—uncertainty shocks generate small increases in output and comovement with consumption and investment that is at odds with the data. We examine three changes to the model—recalibration, a risk-premium shock, and a disaster risk-type shock—to try and restore their results, but in all three cases the model is unable to match VAR evidence.

Keywords: Stochastic Volatility; Epstein-Zin Preferences; Uncertainty; Economic Activity;

JEL Classification: D81; E32;

https://doi.org/10.24149/wp1706