Uncertainty shocks, inflation dynamics and monetary policy

Project Information

UNMACRODYN

Grant agreement ID: 840187

DOI

10.3030/840187

Project closed

EC signature date 10 April 2019

Start date 1 October 2019

End date 30 September 2021

Funded under

• EXCELLENT SCIENCE - Marie Skłodowska-Curie Actions

Total cost

€ 224 933,76

EU contribution

€ 224 933,76

Coordinated by

QUEEN MARY UNIVERSITY OF LONDON
United Kingdom

Periodic Reporting for period 1 - UNMACRODYN (Uncertainty shocks, inflation dynamics and monetary policy)

Reporting period: 2019-10-01 to 2021-09-30

Summary of the context and overall objectives of the project

The research project under the MSCA IF – UNMACRODYN (GA 840187) aimed to investigate the transmission of increased monetary uncertainty to the business cycle. The main target of the analysis was studying the impact of heightened uncertainty on firms’ decisions of entry and exit from the market. The research project focused on a shock to a specific kind of uncertainty, namely the uncertainty about future monetary policy decisions, and on specific macroeconomic variables consisting of the extensive margin of investment, namely the entry and exit of firms from the market. Importantly, the monetary policy uncertainty the research project focuses on refers to the perceived uncertainty that households and firms have on the decisions of the Central Bank, and eventually on the future stance of the monetary policy.
Economic agents like households and firms face problems that incorporate an intertemporal dimension. In choosing the level of saving and investment, economic agents know that current decisions have implications for the future. When solving intertemporal problems, households and firms discount the future implications to the present. Notably, the discount rate at which future returns of current saving and investment are priced is ultimately related to the policy rate set by the Central Bank. Higher uncertainty around the future monetary policy decisions makes therefore the discounted future returns more uncertain too. As a consequence, precautionary behaviors of consumers and firms might curb economic activity.
Interestingly, firm decisions to enter and exit from the market involve intertemporal aspects too. When firms evaluate whether to enter the market, they compare the cost of entry to the discounted future profits they gain when settling in. When firms evaluate whether to exit from the market, they compare the liquidation value to the discounted foregone future profits they miss to gain. Less precise expectations about the future outcome might induce more firms to postpone entry into the market or anticipate exit.
The analysis proposed in the research project shows that monetary policy uncertainty shocks are recessionary and deflationary. Firm entry and exit decrease and increase respectively, in response to these shocks. Interestingly, the implied recession caused by monetary policy uncertainty shocks does not prevent aggregate productivity from responding positively at least at the medium horizon.
The research project first contributed to shedding light on the effect of heightened monetary policy uncertainty on both standard macroeconomic variables and firm dynamics. Second, it contributed to providing insights for policymakers, and more specifically Central Banks, on the importance of the perceived uncertainty around their future decisions. Third, for more general interest, the research project contributed to understanding if monetary policy uncertainty can cause precautionary behaviors by consumers and firms.

Work performed from the beginning of the project to the end of the period covered by the report and main results achieved so far

Working on the research project has comprised different activities for several work packages. In the first part of the research project, from m1 to m6, most of the activities concerned training and collection of the data. From m7 to m12, the activities included working on both empirical and theoretical exercises proposed in the project. During the same period, a first draft of the paper, entitled “Monetary Policy Uncertainty and Firm Dynamics” was written and then submitted to two international peer-reviewed journals. Later, from m13 to m18, the paper was presented in several seminars and conferences. It was also presented at the European Economic Job Market 2020. Finally, from m19 to m21, the research paper was submitted to another peer-reviewed scientific journal and presented to more conferences.
The paper investigates the transmission channel of firm dynamics for monetary policy uncertainty shocks first in the data and then in a theoretical model. In both exercises, the identified monetary policy uncertainty shock triggers a recession, declining firm entry, and rising firm exit.
A separate set of activities developed during the fellowship regards divulgation. During the first months (from m1 to m6), related activities regarded the organization of the workshop on “Non-linearities in Macroeconomics” that would have been scheduled for June 2020. Because of the outbreak of the Covid 19 pandemic and the limitations that follow for the organization of social events in the U.K. the workshop was suspended and postponed after the end of the fellowship. In the second part of the first year (from m7 to m12), the project was first presented at QMUL and then at the Bank of England. During the second year, the research project was presented many times. Among others, presentations were given at De Nederlandsche Bank, the European Economic Job Market 2020, and many international conferences. In total, the research project was presented in seven seminars, one workshop, and eight conferences. Considering the limitations in organizing and participating in academic events during times of the Covid-19, the record of dissemination is remarkable.

Progress beyond the state of the art and expected potential impact (including the socio-economic impact and the wider societal implications of the project so far)

The research project relates to two main strands of the economic literature. First, it relates to the literature studying the macroeconomic effects of policy uncertainty shocks. The research project innovates from the flourishing literature started by Bloom (Econometrica, 2009) among others, along at least three dimensions. First, it focuses on a specific kind of uncertainty, which concerns the monetary policy, and thereby, it is policy-related. Second, it provides empirical evidence both at the aggregate and industry level. Third, it proposes a theoretical model in which heterogeneous productivity at the firm level is crucial for explaining variations in aggregate productivity to business cycle fluctuations.
The second strand of the economic literature this research project is related to is about the role of firm dynamics in explaining the business cycle (Bilbiie et al. (Journal of Political Economy, 2012), among others). This research project innovates over the previous contribution proposing a general equilibrium model that is otherwise standard but augmented by three key ingredients. In addition to heterogeneous productivity at the firm level, the model is augmented with an endogenous mechanism of entry and exit, and stochastic volatility to the monetary policy shock.
Given the research question, potential interest in the project can be detected from a policymaking perspective. The results of the project show that the induced recession from monetary policy uncertainty might have more severe effects than that generated by a tightening in the monetary policy stance. Therefore, monetary authorities should be aware that heightened perceived uncertainty around the decisions and measures they might deploy matters for macroeconomic variables.
Of more general interest, the findings of the project indicate that households and firms are concerned with the variability of the rate at which they discount future returns. This variability is related to the uncertainty around the monetary policy. Because of precautionary motives, a higher monetary policy uncertainty can be detrimental to investment decisions and weakens economic activity.

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