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On the Size Distribution of Macroeconomic Disasters

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Author Info
Robert J. Barro
Tao Jin

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Abstract

In the rare-disasters setting, a key determinant of the equity premium is the size distribution of macroeconomic disasters, gauged by proportionate declines in per capita consumption or GDP. The long-term national-accounts data for up to 36 countries provide a large sample of disaster events of magnitude 10% or more. For this sample, a power-law density provides a good fit to the distribution of the ratio of normal to disaster consumption or GDP. The key parameter of the size distribution is the upper-tail exponent, α, estimated to be near 5, with a 95% confidence interval between 3-1/2 and 7. The equity premium involves a race between α and the coefficient of relative risk aversion, γ. A higher α signifies a thinner tail and, therefore, a lower equity premium, whereas a higher γ implies a higher equity premium. The equity premium is finite if α 1>γ. To accord with the observed average unlevered equity premium of around 5%, we get a point estimate for γ close to 3, with a 95% confidence interval of roughly 2 to 4.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15247.

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Date of creation: Aug 2009
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Handle: RePEc:nbr:nberwo:15247

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Find related papers by JEL classification:
E20 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
G01 - Financial Economics - - General - - - Financial Crises
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  2. Xavier Gabaix & Parameswaran Gopikrishnan & Vasiliki Plerou & H. Eugene Stanley, 2006. "Institutional Investors and Stock Market Volatility," The Quarterly Journal of Economics, MIT Press, vol. 121(2), pages 461-504, May. [Downloadable!] (restricted)
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  6. 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)
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