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Dynamics of Uncertainty Shocks and The Role of External-Debt-Financed Fiscal Policy

Zahran, M. S. A. Z. (2024). Dynamics of Uncertainty Shocks and The Role of External-Debt-Financed Fiscal Policy. (Unpublished Doctoral thesis, City, University of London)


The effect of heightened “macroeconomic uncertainty” on economic activity is a key topic of research. Knight (1921) defines uncertainty as people’s inability to forecast the likelihood of future events or outcomes for a given phenomenon happening in the future. However, due to its unobserved inherent and non-objective nature, measuring economic uncertainty is a crucial challenge in the macroeconomic literature. Several measures of uncertainty have been suggested relying on various proxies on different levels, such as counting words’ occurrence in news publications, modelling stochastic volatility either in the stock market returns or a rich data environment with hundreds of macroeconomic variables, the cross-sectional dispersion of firm productivity, profit, and stock returns, and variations in subjective survey expectations. This thesis focuses on the implications of both macroeconomic and fiscal policy uncertainties. Macroeconomic uncertainty is defined as the conditional volatility in the purely unforecastable component of the future value of macro time series variables, following Jurado et al. (2015), while fiscal policy uncertainty (FPU) denotes uncertainty regarding the future path of fiscal policy, following Baker et al. (2016). Theoretically, the FPU is modelled as a volatility shock, "second-moment innovation", to fiscal policy instruments such as government spending in an autoregressive process as in Fernández-Villaverde et al. (2011).

Although it is well-established that economic uncertainty about the future varies over time and affects significantly resource reallocation by declining output, employment and investment with deflationary effects i.e. a negative demand shock, the literature pins down the aggregate average effects of uncertainty in the macroeconomy without accounting for its sources. Hence, one can argue that the macroeconomy’s endogenous responses to an exogenous macroeconomic uncertainty shock can change depending on the source of the shock. That motivates me to introduce new time-varying ex-ante uncertainty estimates for the business and household sectors based on household-business data distinction in Chapter 2. Unlike the previous studies on measuring uncertainty, I relax the assumption of the precise knowledge of the forecasting model by allowing for different forecasting models to hold at different points in time and select the best forecasting model for each period. This approach improves the overall forecast remarkably and changes the prediction errors, thereby displaying more significant independent variations than indicated in the literature.

In Chapter 3, I argue that the policy conduct itself can be a source of fluctuations in economic aggregates and instability in the macroeconomy if it is surrounded by uncertainty about the future path. Although a handful of recent papers have mainly focused on addressing the effects of either the aggregate economic policy uncertainty index of Baker et al. (2016) or different measures of monetary policy uncertainly (for example, see Husted et al., 2020; Bauer et al., 2019), testing the impact of fiscal policy uncertainty on economic activity has attracted significantly less attention. That chapter adds to the literature by re-examining the evidence for real effects of FPU in aggregate data considering different measures6 that neither have gotten attention nor strictly been used before in the empirical literature. Moreover, theoretically, I tested the effects of FPU modelled as unexpected changes in government spending volatility on economic activity in a standard representative-agent New Keynesian (RANK) mode with the Rotemberg pricing setting assumption. Thus, this thesis focuses on the dynamic real effects of three dimensions of uncertainty: business-induced uncertainty (ZBU), household-induced uncertainty (ZHU), and government-induced uncertainty (FPU).

Furthermore, apart from FPU, chapter 4 investigates the role of fiscal policy “level shock” and its source of finance in mitigating the negative effects of macrocosmic uncertainty “secondmoment” which have different frequency and persistence properties. One can think about a net effect of two opposite shocks. In particular, there is an expansionary government expenditure shock, which is countercyclical with stimulative effects on output aiming to help jump-start economic growth, that works against a simultaneous macro uncertainty shock, which drives business cycles and shifts the state of the economy with adverse contraction effects on output. I distinguish the effects of debt-financed government spending broken down by the source of borrowing (domestic- and foreign-debt-financed spending). Eventually, I introduce a new inference on the size of government spending multipliers across high and low business cycle frequencies and time using a continuous wavelet tool called " the partial wavelet gain", first introduced by Aguiar-Conraria et al. (2018).

Main Findings
The results reveal that an aggregate macroeconomic uncertainty rules out or ignores significant episodes of high uncertainty. More specifically, it does not capture few business sector-specific shocks that wash out in the aggregate data. Interestingly, episodes of high uncertainty in the business sector are mainly explained by uncertainties in trade & investment, and financial blocks, while uncertainties in income and price blocks cause high household uncertainty. Moreover, an unexpected increase in any of the three sources of uncertainty, namely, ZBU, ZHU, and FPU have adverse effects on output and economic activity. However, in the first two quarters after the shock, the response of prices differs depending on the sources of uncertainty, suggesting ZBU resembles the impact of a negative supply shock in the short-run. Also, the variance decomposition analysis of the Diebold-Yilmaz index show that ZBU is more exogenous than ZHU and FPU.

Further results show that despite of the adverse effects of big persistent uncertainty shocks, which are associated positively with bad news and negatively with consumer confidence, in the macroeconomy, financing the fiscal spending shocks largely by foreign savings enhances agents’ confidence and generates stimulative effects on output and its components. In contrast, financing the shock primarily by domestic debt detracts resources from the private sector and disproves firms’ expectations, implying significant crowding-out effects. Although the findings show, on average, less than unity multiplier over the sample period, it is greater than unity after the global financial crisis and the COVID-19 pandemic. In addition, the magnitude of estimated multipliers is, on average, larger at low-frequency business cycles than at high frequencies.

Publication Type: Thesis (Doctoral)
Subjects: H Social Sciences > HB Economic Theory
Departments: School of Policy & Global Affairs > Economics
School of Policy & Global Affairs > School of Policy & Global Affairs Doctoral Theses
Doctoral Theses
[thumbnail of Zahran 2024 thesis.pdf] Text - Accepted Version
This document is not freely accessible until 28 February 2027 due to copyright restrictions.


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