UNMACRODYN · Uncertainty shocks, inflation dynamics and monetary policy

Uncertainty shocks, inflation dynamics and monetary policy

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.

Data: CORDIS, © European Union