The Real Response to Uncertainty Shocks: the Risk Premium Channel

Abstract

Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty increases risk and elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant risk premia in bad times, which in turn exacerbate the decline of macroeconomic aggregates and equity prices. Moreover, uncertainty is a priced risk factor in the cross-section of equity returns only when the factor exposure is a time-varying function of RA. In a model with endogenously time-varying RA, uncertainty produces large falls in investment and equity prices that closely match state-dependent data responses.

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

JEL Classification: C32, C63, E32, E44