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Rare Disasters, Asset Prices, and Welfare Costs

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Robert J. Barro

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Abstract

A representative-consumer model with Epstein-Zin-Weil preferences and i.i.d. shocks, including rare disasters, accords with observed equity premia and risk-free rates if the coefficient of relative risk aversion equals 3-4. If the intertemporal elasticity of substitution exceeds one, an increase in uncertainty lowers the price-dividend ratio for equity, and a rise in the expected growth rate raises this ratio. Calibrations indicate that society would willingly reduce GDP by around 20 percent each year to eliminate rare disasters. The welfare cost from usual economic fluctuations is much smaller, though still important, corresponding to lowering GDP by about 1.5 percent each year. (JEL E13, E21, E22, E32)

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File URL: http://hdl.handle.net/10.1257/aer.99.1.243
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 99 (2009)
Issue (Month): 1 (March)
Pages: 243-64
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Handle: RePEc:aea:aecrev:v:99:y:2009:i:1:p:243-64

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  2. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08. [Downloadable!] (restricted)
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  3. Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February. [Downloadable!] (restricted)
  4. Kocherlakota, Narayana R, 1990. " Disentangling the Coefficient of Relative Risk Aversion from the Elasticity of Intertemporal Substitution: An Irrelevance Result," Journal of Finance, American Finance Association, vol. 45(1), pages 175-90, March. [Downloadable!] (restricted)
  5. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July. [Downloadable!] (restricted)
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  9. repec:fth:harver:1421 is not listed on IDEAS
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  11. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  12. Chatterjee, Satyajit & Corbae, Dean, 2007. "On the aggregate welfare cost of Great Depression unemployment," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1529-1544, September. [Downloadable!] (restricted)
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  13. Andrew Atkeson & Christopher Phelan, 1994. "Reconsidering the Costs of Business Cycles with Incomplete Markets," NBER Working Papers 4719, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  14. Salyer, Kevin D., 2007. "Macroeconomic priorities and crash states," Economics Letters, Elsevier, vol. 94(1), pages 64-70, January. [Downloadable!] (restricted)
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  16. Obstfeld, Maurice, 1994. "Evaluating risky consumption paths: The role of intertemporal substitutability," European Economic Review, Elsevier, vol. 38(7), pages 1471-1486, August. [Downloadable!] (restricted)
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  17. Robert E. Lucas, 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March. [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Robert Barro, 2009. "EconomicDynamics Interviews Robert Barro on Rare Events," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 10(2), April. [Downloadable!]
  2. Robert J. Barro & Tao Jin, 2009. "On the Size Distribution of Macroeconomic Disasters," NBER Working Papers 15247, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Tim Bollerslev & Viktor Todorov, 2009. "Tails, Fears and Risk Premia," CREATES Research Papers 2009-26, School of Economics and Management, University of Aarhus. [Downloadable!]
  4. Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "Banking Crises: An Equal Opportunity Menace," NBER Working Papers 14587, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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