The long-run effects of uncertainty shocks
Bank of England 2019.06.24
This paper argues that shocks increasing macroeconomic uncertainty negatively affect economic activity not only in the short but also in the long run. In a sticky-price DSGE model with endogenous-growth through investment in R&D, uncertainty shocks lead to a short-term fall in demand because of precautionary savings and rising markups. The decline in the utilised aggregate stock of R&D determines a fall in productivity, which causes a long-term decline in the main macroeconomic aggregates. When households feature Epstein-Zin preferences, they become averse to these long-term risks affecting their consumption process (long-run risk channel), which strongly exacerbates the precautionary savings motive and the overall negative effects of uncertainty shocks.