TWO APPROACHES TO MODELING UNCERTAINTY: HOW DID UNCERTAINTY AFFECT THE ECONOMY DURING AND AFTER THE GREAT RECESSION?

Abstract

Recent research in macroeconomics has sought to develop a tractable form of heterogeneity in attempting to model sluggish responses in the price level. In addition, economists have struggled to explain why the demand for safe assets has increased as evidenced by the decline in real interest rates and even nominal interest rates in the last three decades [King, M (2017). Uncertainty and large swings in activity. In National Bureau of Economic Research Martin Feldstein Lecture, Cambridge, MA: NBER Summer Institute; King, M and D Low (2014). Measuring the ‘World’ Interest Rate. National Bureau of Economic Research Working Paper 19887, Cambridge, MA]. We build a simple two-period lived overlapping generations model that displays both heterogeneity of expectations and robustness. Our goal is to derive the economic impacts associated with greater uncertainty; more specifically, to answer the question can these two versions of uncertainty account for an increase in the demand for money and the low return on safe assets? Since analysis of even such a simple model requires a lot of technical work, we put most of this technical work into a rather lengthy technical Appendix for the benefit of readers who wish to follow such details. The main text in the paper will just focus on the basic economics.