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A New Way to Quantify the Effect of Uncertainty

No. 1705

Alexander W. Richter and Nathaniel A. Throckmorton

Abstract: This paper develops a new method to quantify the effects of uncertainty using estimates from a nonlinear New Keynesian model. The model includes an occasionally binding zero lower bound constraint on the nominal interest rate, which creates time-varying endogenous uncertainty, and two exogenous types of time-varying uncertainty—a volatility shock to technology growth and a volatility shock to the risk premium. A filtered third-order approximation of the Euler equation shows consumption uncertainty on average reduced consumption by about 0.06% and the peak effect was 0.15% during the Great Recession. Other higher-order moments such as inflation uncertainty, technology growth uncertainty, consumption skewness, and inflation skewness had smaller effects. Technology growth volatility explained most of the changes in uncertainty, but risk premium volatility had a major role in the last two recessions.

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