Rare Disasters, Asset Prices, and Welfare Costs

44 Pages Posted: 21 Dec 2007 Last revised: 28 Dec 2007

See all articles by Robert J. Barro

Robert J. Barro

Harvard University - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: December 2007

Abstract

A representative-consumer model with Epstein-Zin-Weil preferences and i.i.d. shocks, including rare disasters, accords with key asset-pricing observations. If the coefficient of relative risk aversion equals 3-4, the model accords with observed equity premia and risk-free real interest rates. If the intertemporal elasticity of substitution is greater than one, an increase in uncertainty lowers the price-dividend ratio for equity, whereas a rise in the expected growth rate raises this ratio. In a model with endogenous saving, more uncertainty lowers the saving ratio (because substitution effects dominate). The match with major features of asset pricing suggests that the model is a reasonable candidate for assessing the welfare cost of aggregate consumption uncertainty. In the baseline simulation, the welfare cost of disaster risk is large -- society would be willing to lower real GDP by as much as 20% each year to eliminate the small chance of major economic collapses. The welfare cost from usual economic fluctuations is much smaller, though still important, corresponding to lowering GDP by around 1.5% each year.

Suggested Citation

Barro, Robert J., Rare Disasters, Asset Prices, and Welfare Costs (December 2007). NBER Working Paper No. w13690. Available at SSRN: https://ssrn.com/abstract=1077816

Robert J. Barro (Contact Author)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States
617-495-3203 (Phone)

National Bureau of Economic Research (NBER)

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United States

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