Risk and Macroeconomic Activity

Abstract

This paper explores the role that risk plays in macroeconomic fluctuations using the spread between Moody's BAA and AAA bond rates as the measure of risk. First, this paper shows that meaningful upward movements in this spread are associated with recessions and these upward movements appear to be larger if the recession is relatively more severe. Second, it shows that adding this spread to a standard money-demand equation causes a significant improvement in money demand stability. Third, it shows that including this spread in a small vector-autoregression model allows the identification of a shock to risk that explains 25% of the forecast error variance of output purchased by the private sector. Finally, this paper uses historical decompositions to show that the shock to risk identified by this paper explains an important part of the declines in output during four post-1970 recessions. Notably, the paper finds that the shock to risk explains almost none of the decline in output during 2001 prior to the September 11 terrorist attacks, but does explain why the recovery was relatively weak until the middle of 2003.

Keywords: VAR, risk, macroeconomics, money demand, business cycle

JEL Classification: E3, E4