Efrem Castelnuovo, University of Padova

"Uncertainty and the Business Cycle When Inflation is High"

Abstract

We employ a nonlinear stochastic volatility-in-mean VAR framework to investigate the effects of macroeconomic uncertainty shocks on the business cycle. We document a larger positive inflation response and a bigger drop in real activity when inflation is high. We interpret our empirical findings with a nonlinear New Keynesian framework featuring second-moment shocks and trend inflation. The interaction between high trend inflation and firms’ upward pricing bias generates a large price dispersion that exacerbates the macroeconomic effects induced by the uncertainty shock. In our model, an aggressive monetary policy response to inflation in the presence of high trend inflation replicates the allocation.

Co-authors: Giovanni Pellegrino and Laust Ladegård Særkjær

Contact person: Søren Hove Ravn