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On the Size Distribution of Macroeconomic Disasters

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  • Robert J. Barro
  • Tao Jin

Abstract

The coefficient of relative risk aversion is a key parameter for analyses of behavior toward risk, but good estimates of this parameter do not exist. A promising place for reliable estimation is rare macroeconomic disasters, which have a major influence on the equity premium. The premium depends on the probability and size distribution of disasters, gauged by proportionate declines in per capita consumption or GDP. Long-term national-accounts data for 36 countries provide a large sample of disasters of magnitude 10% or more. A power-law density provides a good fit to the size distribution, and the upper-tail exponent, α, is estimated to be around 4. A higher α signifies a thinner tail and, therefore, a lower equity premium, whereas a higher coefficient of relative risk aversion, γ, implies a higher premium. The premium is finite if α > γ. The observed premium of 5% generates an estimated γ close to 3, with a 95% confidence interval of 2 to 4. The results are robust to uncertainty about the values of the disaster probability and the equity premium and can accommodate seemingly paradoxical situations in which the equity premium may appear to be infinite.

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Paper provided by Harvard University OpenScholar in its series Working Paper with number 115416.

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Handle: RePEc:qsh:wpaper:115416

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Cited by:
  1. Dolmas, Jim, 2013. "Disastrous disappointments: asset-pricing with disaster risk and disappointment aversion," Working Papers, Federal Reserve Bank of Dallas 1309, Federal Reserve Bank of Dallas.
  2. Larry G. Epstein & Emmanuel Farhi & Tomasz Strzalecki, 2013. "How Much Would You Pay to Resolve Long-Run Risk?," NBER Working Papers 19541, National Bureau of Economic Research, Inc.
  3. Salvador Pueyo, 2013. "Is it a power law distribution? The case of economic contractions," Papers 1310.2567, arXiv.org.
  4. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Rare Disasters: Implications for Consumptions and Asset Prices," CEU Working Papers, Department of Economics, Central European University 2014_2, Department of Economics, Central European University.
  5. Robert J. Barro & José F. Ursúa, 2012. "Rare Macroeconomic Disasters," Annual Review of Economics, Annual Reviews, Annual Reviews, vol. 4(1), pages 83-109, 07.
  6. Adam, Klaus & Grill, Michael, 2012. "Optimal Sovereign Default," Working Papers, University of Mannheim, Department of Economics 12-16, University of Mannheim, Department of Economics.
  7. Lars-Alexander Kuehn & Nicolas Petrosky-Nadeau & Lu Zhang, 2012. "An Equilibrium Asset Pricing Model with Labor Market Search," NBER Working Papers 17742, National Bureau of Economic Research, Inc.
  8. Robert S. Pindyck, 2013. "The Climate Policy Dilemma," Review of Environmental Economics and Policy, Association of Environmental and Resource Economists, vol. 7(2), pages 219-237, July.
  9. Joshua Aizenman & Ilan Noy, 2013. "Public and Private Saving and the Long Shadow of Macroeconomic Shocks," NBER Working Papers 19067, National Bureau of Economic Research, Inc.
  10. Kadan, Ohad & Liu, Fang, 2014. "Performance evaluation with high moments and disaster risk," Journal of Financial Economics, Elsevier, Elsevier, vol. 113(1), pages 131-155.
  11. Jerry Tsai & Jessica A. Wachter, 2014. "Rare Booms and Disasters in a Multi-sector Endowment Economy," NBER Working Papers 20062, National Bureau of Economic Research, Inc.
  12. repec:bos:wpaper:wp2013-002 is not listed on IDEAS
  13. Max Gillman & Michal Kejak & Michal Pakos, 2014. "Learning about Disaster Risk: Joint Implications for Consumption and Asset Prices," CERGE-EI Working Papers, The Center for Economic Research and Graduate Education - Economic Institute, Prague wp507, The Center for Economic Research and Graduate Education - Economic Institute, Prague.

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