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Faculty of Economics

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Freund, L. B., Lee, H. and Rendahl, P.

The Risk-Premium Channel of Uncertainty: Implications for Unemployment and Inflation

Review of Economic Dynamics, forthcoming


Abstract: This paper studies the role of macroeconomic uncertainty in a search-and-matching framework with risk-averse households. Heightened uncertainty about future productivity reduces current economic activity even in the absence of nominal rigidities. A risk-premium mechanism accounts for this result. As future asset prices become more volatile and covary more positively with aggregate consumption, the risk premium rises in the present. The associated downward pressure on current asset values lowers firm entry, making it harder for workers to find jobs and reducing the supply of goods. With nominal rigidities the recession is exacerbated, as a more uncertain future reinforces households' precautionary behavior, which causes demand to contract. Counterfactual analyses using a calibrated model imply that unemployment would rise by less than half as much absent the risk-premium channel. The presence of this mechanism implies that uncertainty shocks are less deflationary than regular demand shocks, nor can they be fully neutralized by monetary policy.

Keywords: inflation, search frictions, Uncertainty, Unemployment

JEL Codes: J64, E21, E32

Author links: Lukas Freund  

Publisher's Link:

Cambridge Working Paper in Economics Version of Paper: The Risk-Premium Channel of Uncertainty: Implications for Unemployment and Inflation, Freund, L. B., Lee, H., Rendahl, P. , (2022)

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