Working Paper: NBER ID: w15399
Authors: Francois Gourio
Abstract: To construct a business cycle model consistent with the observed behavior of asset prices, and study the effect of shocks to aggregate uncertainty, I introduce a small, time-varying risk of economic disaster in a standard real business cycle model. The paper establishes two simple theoretical results: first, when the probability of disaster is constant, the risk of disaster does not affect the path of macroeconomic aggregates - a "separation theorem" between macroeconomic 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. An increase in the perceived probability of disaster leads to a collapse of investment and a recession, an increase in risk spreads, and a decrease in the yield on safe assets. To assess the empirical validity of the model, I infer the probability of disaster from observed asset prices and feed it into the model. The variation over time in this probability appears to account for a significant fraction of business cycle dynamics, especially sharp downturns in investment and output such as 2008-IV.
Keywords: business cycles; risk premia; economic disaster; macroeconomic dynamics
JEL Codes: E32; E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Constant probability of disaster (H84) | No effect on macroeconomic aggregates (E19) |
| Increase in perceived probability of disaster (H84) | Collapse in investment (E22) |
| Collapse in investment (E22) | Recession (E32) |
| Increase in perceived probability of disaster (H84) | Recession (E32) |
| Time-varying disaster risk (H84) | Preference shocks (D11) |