Risk Aversion and the Response of the Macroeconomy to Uncertainty Shocks

73 Pages Posted: 22 Mar 2017 Last revised: 9 Jul 2018

See all articles by Lorenzo Bretscher

Lorenzo Bretscher

London Business School - Department of Finance; affiliation not provided to SSRN

Alex Hsu

Georgia Institute of Technology - Scheller College of Business

Andrea Tamoni

London School of Economics & Political Science (LSE)

Date Written: May 17, 2018

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

Suggested Citation

Bretscher, Lorenzo and Hsu, Alex and Tamoni, Andrea, Risk Aversion and the Response of the Macroeconomy to Uncertainty Shocks (May 17, 2018). 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 Business School - Department of Finance ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

affiliation not provided to SSRN

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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