Econometrica: Jul 2018, Volume 86, Issue 4

Uncertainty Shocks in a Model of Effective Demand: Comment

DOI: 10.3982/ECTA15405
p. 1513-1526

Oliver de Groot, Alexander W. Richter, Nathaniel A. Throckmorton

Basu and Bundick, 2017 showed an intertemporal preference volatility shock has meaningful effects on real activity in a New Keynesian model with Epstein and Zin, 1991 preferences. We show that when the distributional weights on current and future utility in the Epstein–Zin time aggregator do not sum to 1, there is an asymptote in the responses to such a shock with unit intertemporal elasticity of substitution. In the Basu–Bundick model, the intertemporal elasticity of substitution is set near unity and the preference shock only hits current utility, so the sum of the weights differs from 1. We show that when we restrict the weights to sum to 1, the asymptote disappears and preference volatility shocks no longer have large effects. We examine several different calibrations and preferences as potential resolutions with varying degrees of success.

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Supplement to "Uncertainty Shocks in a Model of Effective Demand: Comment"

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Supplement to "Uncertainty Shocks in a Model of Effective Demand: Comment"

This supplement extends our analysis along three dimensions. One, it provides additional analytical results that show how the specification of the preference shock in recursive, Epstein and Zin (1991), preferences affects equilibrium outcomes. Two, it explores the implications of using a risk premium shock instead of a preference shock and additively separable preferences in consumption and leisure. Three, it conducts further sensitivity analysis on the parameters.

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