Risk Aversion and the Response of the Macroeconomy to Uncertainty Shocks

Abstract

The degree of risk aversion (RA) determines the impact of uncertainty shocks in DSGE models. Ceteris paribus, a higher coefficient of risk aversion leads to an amplification of macroeconomic responses to uncertainty shocks in standard New Keynesian models. Theoretically, we show that an economy with endogenously time-varying risk aversion can generate large responses to uncertainty shocks. Empirically, and consistent with model predictions, we show that RA exacerbates the impact of uncertainty shocks. In particular, heightened levels of RA during the 2008 crisis amplified the drop in output and investment by 21% and 16%, respectively, at the recession trough.

Keywords: Risk Aversion, Uncertainty, Conditional IRF, Dynamic Economies.

JEL Classification: C32, C63, E32, E44