The Relative Importance of Monetary Policy, Uncertainty, and Financial Shocks
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The Relative Importance of Monetary Policy, Uncertainty, and Financial Shocks Cosmas Dery1 · Apostolos Serletis1
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract Motivated by recent research suggesting that uncertainty and financial shocks have become the most important sources of business cycle fluctuations, we assess the relative importance of monetary policy, uncertainty, and financial shocks in explaining key macroeconomic variations. Using a Bayesian monetary structural vector autoregressive model augmented with measures of uncertainty and tightness of financial conditions, we identify monetary policy, uncertainty, and financial shocks based on a penalty function approach. We find that uncertainty shocks have become a relatively more important source of output fluctuations than traditional monetary policy shocks and financial shocks. We also find that monetary policy shocks outperform uncertainty and financial shocks in explaining inflation dynamics and that financial shocks are relatively more important than monetary policy and uncertainty shocks in explaining the swings in the stock market. However, these shocks are not the major driver of exchange rates. Keywords Uncertainty shocks · Monetary policy shocks · Financial shocks · Output · Inflation JEL Classification E32 · E44 · E52 · E58
1 Introduction In recent years economists have questioned the importance of traditional sources of business cycle drivers such as monetary policy shocks. For example, Baumeister and Hamilton (2018) conclude that monetary policy shocks are relatively unimportant in explaining key macroeconomic variations compared to demand and supply shocks. Also, as (Caldara et al. 2016 p. 185) put it, “the acute turmoil that swept through Apostolos Serletis
[email protected] 1
Department of Economics, University of Calgary, Calgary, AB, T2N 1N4, Canada
C. Dery, A. Serletis
global financial markets during the 2008-2009 financial crisis and the depth and duration of the associated economic downturn, both in the United States and abroad, have cast a considerable doubt on the traditional sources of business cycle fluctuations. In response, recent theoretical and empirical research aimed at understanding these extraordinary events has pointed to financial and uncertainty shocks — or their combination — as alternative drivers of economic fluctuations.” Moreover, (Davis 2019, p. 13) argues that “a variety of studies find evidence that high (policy) uncertainty undermines economic performance by leading firms to delay or forego investments and hiring, by slowing productivity-enhancing factor reallocation, and by depressing consumption expenditures. This evidence points to a positive payoff in the form of stronger macroeconomic performance if policymakers can deliver greater predictability in the policy environment.” The question therefore is how important are monetary policy shocks relative to uncertainty and financial shocks as sources of macroeconomic fluctuations? In this paper, we follow Caldara et al. (2
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