Uncertainty Shocks in an Economy with Collateral Constraints

Julia Thomas and Aubhik Khan

No 1075, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: We show that a rise in uncertainty on its own generates a substantial drop in employment, production and investment. In keeping with previous findings in the literature, we find these initial declines are larger in the presence of capital irreversibility than without, as firms experiencing relatively high productivity invest less to avoid costs associated with later reversals. Surprisingly, the inclusion of financial frictions has a slight mitigating effect on the downturn. We trace this to a reduced negative wealth effect on labor supply associated with future rises in average productivity implied by the coming greater dispersion. Absent frictions in capital reallocation, greater dispersion has a TFP enhancing effect. This positive effect associated with increased dispersion over coming dates is limited in the presence of collateralized borrowing limits hindering reallocation. Thus, we see substantially reduced rises in GDP over the episode following the uncertainty shock. In contrast to the implications of an aggregate productivity shock, an uncertainty shock generates a gradual rise in endogenous aggregate TFP in our model, alongside a nonmonotone response in the labor input. Thus, when driven by uncertainty shocks alone, the model succeeds in reproducing the near-zero correlation between hours and labor productivity in the data.

Date: 2012
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