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Uncertainty, Financial Frictions, and Investment Dynamics
Micro- and macro-level evidence indicates that fluctuations in idiosyncratic uncertainty have a large effect on investment; the impact of uncertainty on investment occurs primarily through changes in credit spreads; and innovations in credit spreads have a strong effect on investment, irrespective of the level of uncertainty. These findings raise a question regarding the economic significance of the traditional "wait-and-see" effect of uncertainty shocks and point to financial distortions as the main mechanism through which fluctuations in uncertainty affect macroeconomic outcomes. The ...
Sovereign Risk Matters: The Effects of Endogenous Default Risk on the Time-Varying Volatility of Interest Rate Spreads
Emerging market interest rate spreads display substantial time-varying volatility. We show that a baseline model with endogenous sovereign default risk can account for such volatility, even in the absence of shocks to the second moments of the exogenous stochastic variables. In particular, the model features a key non-linearity that allows it to replicate the volatility of interest rate spreads and its comovement with other economic variables. Volatility correlates positively with the level of the spreads and the trade balance and negatively with output and consumption.