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Risk Aversion and the Response of the Macroeconomy to Uncertainty Shocks

52 Pages Posted: 22 Mar 2017 Last revised: 13 Dec 2017

Lorenzo Bretscher

London School of Economics & Political Science (LSE)

Alex C. Hsu

Georgia Institute of Technology - Scheller College of Business

Andrea Tamoni

London School of Economics & Political Science (LSE)

Date Written: December 12, 2017

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 uncertainty shocks. The output, consumption and investment responses roughly double in various models following uncertainty shocks as RA increases from 5 to 15, making uncertainty shocks as economically significant as level shocks. Conversely, elevated RA can amplify or dampen responses to level shocks depending on whether RA exaggerates or attenuates consumption growth expectations. Last, not all uncertainty shocks are created equal: second moment shocks to productivity induce very little movement in macroeconomic aggregates due to the hedging property of capital. Our findings add 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: Risk Aversion, Uncertainty, Dynamic Economies.

JEL Classification: C32, C63, E32, E44

Suggested Citation

Bretscher, Lorenzo and Hsu, Alex C. and Tamoni, Andrea, Risk Aversion and the Response of the Macroeconomy to Uncertainty Shocks (December 12, 2017). Georgia Tech Scheller College of Business Research Paper No. 17-13. Available at SSRN: https://ssrn.com/abstract=2938361 or http://dx.doi.org/10.2139/ssrn.2938361

Lorenzo Bretscher

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Alex Hsu

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States
4043851123 (Phone)

Andrea Tamoni (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
02079557303 (Phone)

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