Working Paper: NBER ID: w26721
Authors: Sebastian Di Tella; Robert E. Hall
Abstract: We develop an equilibrium theory of business cycles driven by spikes in risk premiums that depress business demand for capital and labor. Aggregate shocks increase firms’ uninsurable idiosyncratic risk and raise risk premiums. We show that risk shocks can create quantitatively realistic recessions, with contractions in employment, consumption, and investment. Business cycles are inefficient—output and employment fall too much during recessions, compared to the constrained-efficient allocation, and consumption should rise. Optimal policy involves stimulating employment and consumption during recessions.
Keywords: business cycles; risk premium; recession; precautionary saving
JEL Codes: E21; E22; E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk premium shocks (G19) | lower demand for labor (J29) |
| risk premium shocks (G19) | lower demand for capital (E22) |
| risk premium shocks (G19) | inefficient recessions (E65) |
| lower demand for labor (J29) | contractions in employment (J63) |
| lower demand for capital (E22) | depresses investment (E22) |
| risk premium shocks (G19) | depress business demand for labor and capital (J23) |
| risk premium shocks (G19) | contractions in consumption (E20) |
| risk premium shocks (G19) | fall in output (E23) |
| risk shocks (D81) | increase in labor wedge (J39) |
| risk shocks (D81) | smaller contraction in capital wedge (F32) |
| risk shocks (D81) | larger fluctuations in output and employment (E39) |
| optimal policy (C61) | stimulate employment and consumption (E20) |