Disaster Risk and Business Cycles

49 Pages Posted: 19 Mar 2010

Date Written: March 16, 2010

Abstract

Most macroeconomic models fail to replicate the level, volatility, and countercyclicality of risk premia which has been documented in empirical research. In this paper, I introduce a tractable business cycle model with a small, exogenously time-varying risk of economic disaster. Both asset prices and macroeconomic aggregates respond to this time-varying risk. The model is consistent with the second moments of quantities, of asset returns, and matches well the relations between quantities and asset prices. An increase in the risk of disaster leads to a collapse of investment and a recession, with no current or future change in productivity. Demand for precautionary savings increases, leading yields on safe assets to fall, while spreads on risky securities increase. 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 fraction of business cycle dynamics, especially sharp downturns in investment and output such as the last quarter of 2008. This is consistent with the then-widespread fear of a repeat of the Great Depression. More broadly, the model suggests that variation in risk premia has an important effect on investment and output.

Keywords: business cycles, investment, production, equity premium, time-varying risk premium, disasters, rare events, jumps

JEL Classification: E32, E44, G12

Suggested Citation

Gourio, Francois, Disaster Risk and Business Cycles (March 16, 2010). AFA 2011 Denver Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1573097 or http://dx.doi.org/10.2139/ssrn.1573097

Francois Gourio (Contact Author)

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

HOME PAGE: http://sites.google.com/site/fgourio

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