DP14690 Unexpected Effects: Uncertainty, Unemployment, and Inflation

Author(s): Lukas Freund, Pontus Rendahl
Publication Date: May 2020
Date Revised: May 2020
Keyword(s): inflation, search frictions, uncertainty, unemployment
JEL(s): E21, E32, J64
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14690

This paper studies the role of uncertainty in a search-and-matching framework with risk-averse households. A mean-preserving spread to future productivity contracts current economic activity even in the absence of nominal rigidities, although the effect is reinforced by the presence of the latter. That is, uncertainty shocks carry both contractionary demand- and supply effects. The reason is that a more uncertain future increases the precautionary behavior of households, which reduces interest rates and contracts demand. At the same time, as future asset prices becomes more volatile and positively covary with aggregate consumption, households demand a larger risk premium, which puts negative pressure on current asset values and thereby contracts supply. Thus, in comparison to a pure negative demand shock, an uncertainty shock puts less deflationary pressure on the economy and, as a result, renders a flatter Phillips curve.