“If there’s one thing that’s certain in business, it’s uncertainty”
- Stephen Covey
Uncertainty impacts everything in the day-to-day life as well as the business world. The economy at large and the financial market are impacted in a way that determines consumption growth, macroeconomic growth, asset prices and equity risk premium, only to name a few. In the paper, “Good and Bad Uncertainty: Macroeconomic and Financial Market Implications” by Segal, Shaliastovich and Yaron, they make an effort to understand the impact of uncertainty by decomposing the aggregate uncertainty into ‘good uncertainty’ and ‘bad uncertainty’ which represents the innovation to macroeconomic growth rate – good and bad respectively.
Through theoretical frameworks and econometric models, the paper deduces the following
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Preferences: A recursive-utility function is used to understand the agent’s risk preferences. This utility function takes into account current consumption, risk-aversion coefficient, subjective discount factor and elasticity of intertemporal substitution (IES - impact of return on savings on current consumption).
The result of this was if risk aversion is more than the reciprocal of IES, then an agent will prefer early resolution of consumption uncertainty, and vice-versa
2. Consumption Dynamics: Here, the model brings out the relationship between both the uncertainties, asset prices and the economic growth. It comprises of: (i) decomposition into good and bad components of total macroeconomic uncertainty, affecting good and bad consumption shocks respectively, (ii) direct impact on future economic growth of macroeconomic volatilities
The result of the model was when good volatility rises, future consumption growth rate rises too and a rise in bad volatility reduces future economic