Uncertainty and the Effectiveness of Monetary and Fiscal Policies

This paper integrates the decision making of a firm facing production uncertainty into the theory of aggregate supply. This integration has two important policy implications. First, if the aggregate demand is not unitary price elastic, the presence of uncertainty reduces the aggregate supply, whether producers are risk neutral or risk averse. Second, given the assumption of decreasing absolute risk aversion an increase in interest rate reduces the aggregate supply, and hence the presence of production uncertainty reduces the effectiveness of fiscal policy whereas it increases that of monetary policy for affecting income