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We investigate the eects of government spending uncertainty shocks in the Euro
Area both empirically and theoretically. Empirically, a stochastic volatility model is
used to extract a measure of uncertainty in the government spending to GDP ratio.
This measure is then introduced in a structural VAR model to show that uncertainty
shocks have recessionary, persistent and humped-shaped eects. We develop a dynamic
New Keynesian model with nancial frictions applying to a portfolio of equity
and long-term government bonds where both assets are imperfectly substitutable to
account for these eects. Key parameters of the model are then estimated using a mix
of Simulated Method of Moments and Minimum Distance Estimation, and the eects
of a government spending uncertainty shocks are correctly replicated. We discuss the
various transmission channels and show that nancial frictions in general and the portfolio
channel { the fact that both assets are imperfectly substitutable { in particular,
act as critical ampliers of the usual transmission channels already discussed in the
literature.
