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Federal Reserve Bank of Dallas
Globalization Institute Working Papers
Understanding the Aggregate Effects of Credit Frictions and Uncertainty
Nathan S. Balke
Enrique Martinez-Garcia
Zheng Zeng

We examine the interaction of uncertainty and credit frictions in a New Keynesian framework. To do so, uncertainty is modeled as time-varying stochastic volatility – the product of monetary policy uncertainty, financial risk (micro-uncertainty), and macrouncertainty. The model is solved using a pruned third-order approximation and estimated by the Simulated Method of Moments. We find that: 1) Micro-uncertainty aggravates the information asymmetry between lenders and borrowers, worsens credit conditions, and has first-order effects on real economic activity. 2) When credit conditions are poor, as indicated by elevated credit spreads, additional micro-uncertainty shocks produce even larger real effects. 3) Poor credit conditions notably affect the transmission mechanism of monetary policy amplifying the real effects of monetary shocks while mitigating the economic boost from TFP shocks. 4) While macro-uncertainty and policy uncertainty exert relatively little direct impact on aggregate economic activity, policy uncertainty accounts for around 40% of the business cycle volatility by affecting the size of monetary policy shocks in the presence of nominal rigidities.

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Nathan S. Balke & Enrique Martinez-Garcia & Zheng Zeng, Understanding the Aggregate Effects of Credit Frictions and Uncertainty, Federal Reserve Bank of Dallas, Globalization Institute Working Papers 317, 20 Jun 2017, revised 01 Oct 2019.
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Note: Original paper and supplement were published in June 2017. Revised paper and supplement were published in October 2019.
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Subject headings:
Keywords: Financial Accelerator; Stochastic Volatility; Monetary Policy Transmission; Nominal Rigidities; Perturbation Methods
DOI: 10.24149/gwp317r1
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