Microeconomic Origins of Macroeconomic Tail Risks
48 Pages Posted: 17 Jan 2015 Last revised: 25 Aug 2015
Date Written: August 13, 2015
We document that even though the normal distribution provides a good approximation to GDP fluctuations, it severely underpredicts "macroeconomic tail risks," that is, the frequency of large economic downturns. Using a multi-sector general equilibrium model, we show that the interplay of idiosyncratic microeconomic shocks and sectoral heterogeneity results in systematic departures in the likelihood of large economic downturns relative to what is implied by the normal distribution. Notably, we also show that such departures can happen while GDP is approximately normally distributed away from the tails, highlighting the qualitatively different behavior of large economic downturns from small or moderate fluctuations. We further demonstrate the special role that input-output linkages play in generating "tail comovements," whereby large recessions involve not only significant GDP contractions, but also large simultaneous declines across a wide range of sectors.
Keywords: Business cycles, Domar weights, large economic downturns, network heterogeneity, input-output linkages, tail risks
JEL Classification: C67, E32
Suggested Citation: Suggested Citation