Uncertainty shocks and the monetary-macroprudential policy mix

How should policymakers respond to uncertainty shocks? To analyze the macroeconomic effects of uncertainty shocks associated with various conventional structural shocks, we develop a New Keynesian model with financial frictions and time-varying volatility, which features a monetary- acroprudential policy mix. We find that it matters whether the economy experiences heightened demand, supply or financial uncertainty. More specifically, the underlying source of uncertainty matters for the shocks’ propagation, aggregate economic outcomes and appropriate policy responses. Financial uncertainty shocks appear to generate stronger effects and a broad complementarity between the interest rate response and the macroprudential policy stance. Supply-side and demand-side uncertainty shocks reveal important trade-offs between price stability and financial stability objectives, despite their quantitative effects being overall modest. Importantly, simulating a financial turmoil scenario reveals that heightened financial uncertainty exacerbates the negative macroeconomic effects triggered by a first-moment financial shock. Our results underscore the importance of timely and accurate identification of uncertainty surges, which is crucial for the appropriate design and calibration of the monetary-macroprudential policy mix.

Keywords: Uncertainty shocks, financial frictions, monetary policy, macroprudential policy
JEL codes E30, E32, E44, E47, E50

Working paper no. 739