Events at CERGE-EI

Bálint Szőke

New York University, USA

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Author: Bálint Szőke

Abstract: This paper studies a stochastic economy with flexible prices in which money has real effects. A representative household faces a portfolio choice between a nominally safe asset that provides transaction services and a risky productive capital with time-varying return volatility. Stochastic volatility and the behavior of the central bank determine an equilibrium asset allocation. When the objective of monetary policy is to stabilize inflation around a fixed target, the nominally safe asset becomes a relatively safe store of value in real terms as well. As a result, in response to higher uncertainty, the private sector shifts resources away from risky capital, causing output and investment to fall. To investigate the resulting non-linear dynamics, I solve the model globally and compute generalized impulse response functions across the support of the stationary distribution. Impulse response functions with respect to volatility shocks exhibit strong state dependence: large falls in investment are more likely in a high-risk (low interest rate) environment than in a low-risk (high interest rate) environment. I use the calibrated model to interpret recent events and find that the model predicts comovements observed among a set of key macro variables during and after the Great Recession.

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Full Text: “Uncertainty Shocks in a Monetary Economy”