Deflationary Financial Shocks and Inflationary Uncertainty Shocks: An SVAR Investigation

What are the economic implications of financial and uncertainty shocks? Financial shocks reduce both output and goods prices, while uncertainty shocks reduce output but raise goods prices. In response to uncertainty shocks, firms increase markups, in line with the theory of self‐insurance against being stuck with too low a price. This explains why goods prices may increase at the onset of a recession and why recessions feature less pronounced deflationary pressures. Both shocks are jointly identified exclusively using restrictions on their contribution to the forecast error of a selected variable at the dates of well‐understood economic events. The restricted shock must be the largest contributor to the forecast error, but only among shocks that move the forecast error in the same direction.