Time-Varying Uncertainty and the Credit Channel

We extend the Carlstrom and Fuerst (American Economic Review, 1997, 87, pp. 893–910) agency cost model of business cycles by including time-varying uncertainty in the technology shocks that affect capital production. We first demonstrate that standard linearization methods can be used to solve the model yet second moments enter the economy's equilibrium policy functions. We then demonstrate that an increase in uncertainty causes, ceteris paribus, a fall in investment supply. We also show that persistence of uncertainty affects both quantitatively and qualitatively the behaviour of the economy. (authors' abstract)