Risk Aversion and the Response of the Macroeconomy to Uncertainty Shocks

Abstract

Degree of risk aversion (RA) determines the impact of second moment shocks in DSGE models featuring stochastic volatility. Ceteris paribus, higher risk aversion leads to stronger responses of macroeconomic variables to volatility shocks, in contrast to the Tallarini (2000) irrelevance result, which still holds with respect to level shocks. The output, consumption, and investment responses roughly double in our model following volatility shocks of the same magnitude as RA increases from 5 to 15, making volatility shocks as economically significant as level shocks in the model. Our result adds another dimension of complication in extending macro-finance models that employ stochastic volatility, such as Bansal and Yaron (2004), from endowment economies to full general equilibrium as macroeconomic and asset pricing moments need to be calibrated simultaneously.

Keywords: Dynamic economies, Uncertainty, Epstein-Zin Preferences

JEL Classification: C32, C63, E32, E44