Risk Aversion, Uninsurable Idiosyncratic Risk, and the Financial Accelerator

Abstract

We develop a tractable model to study jointly the role of non-diversifiable risk and financial frictions for business cycles. Non-diversifiable risk induces strong precautionary motives, which reduce the exposure of entrepreneurs to aggregate disturbances ex-ante, and make it easier to increase leverage ex-post. In general equilibrium, these precautionary motives dampen fluctuations in asset prices and risk premia, thus making the economy more resilient to financial shocks. We provide microeconomic evidence consistent with the model’s predictions about firm behavior.

Keywords: Risk Aversion; Uninsurable Idiosyncratic Risk; Financial Accelerator; Incomplete Markets

JEL Classification: C68, D81, D82, E44, L26