Uncertainty and Monetary Policy During Extreme Events

How damaging are uncertainty shocks during extreme events such as the great recession
and the Covid-19 outbreak? Can monetary policy limit output losses in such situations?
We use a nonlinear VAR framework to document the large response of real activity to a
financial uncertainty shock during the great recession. We replicate this evidence with an
estimated DSGE framework featuring a concept of uncertainty comparable to that in our
VAR. We employ the DSGE model to quantify the impact on real activity of an uncertainty
shock under different Taylor rules estimated with normal times vs. great recession data
(the latter associated with a stronger response to output). We find that the uncertainty
shock-induced output loss experienced during the 2007-09 recession could have been
twice as large if policymakers had not responded aggressively to the abrupt drop in output
in 2008Q3. Finally, we use our estimated DSGE framework to simulate different paths of
uncertainty associated to different hypothesis on the evolution of the coronavirus
pandemic. We find that: i) Covid-19-induced uncertainty could lead to an output loss twice
as large as that of the great recession; ii) aggressive monetary policy moves could reduce
such loss by about 50%.