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Disaster risk and business cycles

  • Francois Gourio

    (Boston University, Dept of Economics)

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.

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Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 1176.

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Date of creation: 2009
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Handle: RePEc:red:sed009:1176
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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