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Risk Premium Shocks Can Create Inefficient Recessions

Author

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  • Sebastian Di Tella
  • Robert Hall

Abstract

We develop a simple flexible-price model of business cycles driven by spikes in risk premiums. Aggregate shocks increase firms’ uninsurable idiosyncratic risk and raise risk premiums. We show that risk shocks can create quantitatively plausible recessions, with contractions in employment, consumption, and investment. Business cycles are inefficient—output, employment, and consumption fall too much during recessions, compared to the constrained-efficient allocation. Optimal policy involves stimulating employment and consumption during recessions.

Suggested Citation

  • Sebastian Di Tella & Robert Hall, 2022. "Risk Premium Shocks Can Create Inefficient Recessions," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 89(3), pages 1335-1369.
    • Handle: RePEc:oup:restud:v:89:y:2022:i:3:p:1335-1369.
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    File URL: http://hdl.handle.net/10.1093/restud/rdab049
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    Cited by:

    1. Bartosz Maćkowiak & Mirko Wiederholt, 2021. "Rational Inattention and the Business Cycle Effects of Productivity and News Shocks," Working Papers hal-03878704, HAL.
    2. Miguel Leon-Ledesma & Katsuyuki Shibayama, 2023. "(Endogenous) Growth Slowdowns," Studies in Economics 2303, School of Economics, University of Kent.

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