Uncertainty and Monetary Policy in Good and Bad Times

We employ a nonlinear VAR to document the asymmetric reaction of real economic activity to uncertainty shocks. An uncertainty shock occurring in recessions triggers an abrupt and deep drop followed by a quick rebound and a temporary overshoot. The same shock hitting in expansions induces a milder slowdown, a longer-lasting recovery, and no overshoot. The employment of linear models is shown to offer a distorted picture of the timing and the severity of heightened uncertainty. Monetary policy responds quite aggressively during bad times, and more mildly during booms. Counterfactual simulations point to monetary policy ineffectiveness during the first months after the shock, especially in recessions, and to policy effectiveness in the medium-term, especially during expansions. This holds true considering as policy tools both the federal funds rate and a long-term interest rate. Our results call for microfounded models admitting nonlinear effects of uncertainty shocks.