Disaster Risk and Business Cycles

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