Volatility and Growth with Recursive Preferences

Abstract

This paper studies the relationship between volatility and long-run growth in a complete market economy with human capital accumulation and Epstein-Zin preferences. There is both cross-country and time-series evidence that volatility is associated with lower growth. Matching this evidence has proved a challenge for growth models with no market failures as they tend to predict the opposite for values of risk aversion higher than unity. However in our model, risk aversion and intertemporal elasticity of substitution are allowed to move independently of each other, and when both are relatively high or relatively low, the relationship between volatility and growth is negative. Indeed this is the case for parametrizations of preferences in line with the literature.

Keywords: Growth and Uncertainty, Epstein-Zin Preferences, Intertemporal Elasticity of Sub- stitution, Risk Aversion

JEL Classification: D92,E22,E32,O49