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On the Size Distribution of Macroeconomic Disasters

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Listed author(s):
  • 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, ?, is estimated to be around 4. A higher ? signifies a thinner tail and, therefore, a lower equity premium, whereas a higher coefficient of relative risk aversion, ?, implies a higher premium. The premium is finite if ? > ?. The observed premium of 5% generates an estimated ? 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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Find related papers by JEL classification:
  • E20 - Macroeconomics and Monetary Economics - - 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; Trading Volume; Bond Interest Rates

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  1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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