Economic uncertainty and the effectiveness of monetary policy

Published on, by Knut Are Aastveit, Gisle James Natvik, Sergio Sola, October 19, 2013.

Many analysts blame uncertainty for at least part of advance nations’ poor economic performance since the crisis. This column discusses new research showing that the economic impact of monetary policy is dampened when uncertainty is high. This means that high uncertainty forces monetary policymakers into a trade-off between acting decisively and acting correctly as policy must be more aggressive than otherwise in order to stabilise economic activity. The finding is particularly stark when uncertainty measures from financial markets are utilised.  

Since the onset of the “Great recession”, economists have struggled to explain why the recovery has been so slow, despite the many policy measures that have been passed to re-invigorate economic activity. One candidate explanation that several have pointed to, for instance Baker, Bloom, Davis and Van Reenen (2012), is economic uncertainty. The argument is that uncertainty is likely to induce cautious behaviour, as decisions made today are more likely to prove “wrong” in the future, in which case they will have to be reversed at some cost.

Uncertainty-induced cautiousness influences the economy in two ways.

First, there is the direct effect that economic activity contracts because fewer firms hire workers and make investments.
Much recent research, such as Bloom (2007), Bachman, Elstner and Sims (2012), Baker, Bloom and Davis (2013) and Jurado, Ludvigsson and Ng (2013), find support of this effect in aggregate data.

Second, there is a somewhat subtler effect that economic policy might become less effective as firms are less willing to make decisions of any kind, and therefore less sensitive to marginal changes in investment and hiring incentives.
While well-understood in theory, this mechanism has not received much empirical attention. We have therefore empirically explored how the macroeconomic impact of monetary policy is affected by the prevailing degree of economic uncertainty.

New research:

Our recent research estimates how uncertainty interacts with the effectiveness of monetary policy “shocks” (Aastveit, Natvik and Sola, 2013). We consider four countries: The US, Canada, the United Kingdom and Norway. For each country, we identify the innovations to monetary policy using conventional techniques suggested elsewhere in the rich literature on monetary policy. Compared to this literature, the novelty of our study is to let the impact of policy interact with a variety of uncertainty measures.1 Following the recent studies of uncertainty we use seven different US-based measures of uncertainty:

  • The US stock-market volatility index2
  • The US corporate-bond spread
  • Forecasters’ disagreement taken from the Federal Reserve Bank of Philadelphia’s Business Outlook Survey
  • A Google-based measure of uncertainty3
  • Two measures of macroeconomic uncertainty created by Jurado et al. (2013)
  • The “economic policy uncertainty index” created by Baker et al. (2013).

Muted influence of monetary policy when uncertainty is high: … //

… Conclusions:

Over the last years economic uncertainty has been given much attention, both by policymakers and in the academic literature, as a potential influence in business cycle fluctuations. Much of the debate has been motivated by concerns that elevated uncertainty might motivate firms and households to delay decisions that are costly to reverse and make them less responsive to policy shocks.

Our findings indicate that indeed monetary policy is less effective when uncertainty is high. This implies that when uncertainty is high, monetary policymakers may face a trade-off between acting decisively and acting correctly, as policy must be more aggressive than otherwise in order to stabilise economic activity.

Our results are consistent with the “caution effect” suggested by economic theory, which maintains that in presence of fixed adjustment costs uncertainty increases agents’ opportunity cost of waiting and therefore makes policy less effective.

Our findings, however, show that the pattern of reduced policy effect is particularly stark when uncertainty measures from financial markets are utilised. This could indicate that financial channels are playing a role. Further research on the exact mechanism behind the policy ineffectiveness effects we find seems warranted.

(full text, graphs, references, notes, links to related articles).


The European Crisis in the context of historical trilemmas, on, by Michael Bordo, Harold James, October 19, 2013;

Strange bedfellows: Italy’s budget crisis unites jobless youth and big business, on Russia Today RT, Oct 20, 2013;

Room for improvement? on Al-Ahram weekly online, by Ahmed Al-Naggar, Sept 17, 2013.

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