Disaster risk and business cycles

In order to develop a model that fits both business cycles and asset pricing facts, this paper introduces a small, time-varying risk of economic disaster in an otherwise standard real business cycle model. This simple feature can generate large and volatile risk premia. The paper establishes two simple theoretical results: first, under some conditions, when the probability of disaster is constant, the risk of disaster does not affect the path of macroeconomic aggregates - a "separation theorem" between quantities and asset prices in the spirit of Tallarini (2000). Second, shocks to the probability of disaster, which generate variation in risk premia over time, are observationally equivalent to preference shocks. These shocks have a significant effect on macroeconomic aggregates: an increase in the perceived probability of disaster can lead to a collapse of investment and a recession, with no current or future change in productivity. This model thus allows analyzing the effect of a shock to "risk aversion" or a "shock to beliefs" on the macroeconomy (e.g. Fall 2008), and generates endogenously a correlation between output and asset prices or risk premia.