Higher-order dynamic effects of uncertainty risk under thick-tailed stochastic volatility

Abstract

Abstract Sudden and uncertain events often cause cross-contagion of risk among various sectors of the macroeconomy. This paper introduces the stochastic volatility shock that follows a thick-tailed Student’s t-distribution into a high-order approximate dynamic stochastic general equilibrium (DSGE) model with Epstein–Zin preference to better analyze the dynamic effect of uncertainty risk on macroeconomics. Then, the high-dimensional DSGE model (DSGE-SV-t) is developed to examine the impact of uncertainty risk on the transmission mechanism among macroeconomic sectors. The empirical research found that uncertainty risk generates heterogeneous impacts on macroeconomic dynamics under different inflation levels and economic states. Among them, a technological shock has the strongest impact on employment and consumption channels. The crowding-out effect of a fiscal policy stimulus on consumption and private investments is relatively weakened when considering uncertainty risk but is more pronounced during periods of high inflation. Uncertainty risk can partly explain the decline in investments and the increase in interest rates and employment rates, given the impact of an agent’s risk preferences. Compared with external economic conditions, the inflation factor has a stronger impact on the macro transmission mechanism caused by uncertainty risk.

Keywords

• Uncertainty risk
• High-dimensional DSGE
• Epstein–Zin preferences
• Stochastic volatility
• Thick tail distribution