Response of the Macroeconomy 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 not only increases risk, but it also 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. Empirically, we document that the data response to the interaction of risk aversion and uncertainty are statistically significant and economically large. Indeed, heightened levels of RA during the 2008 crisis amplified the drop at the recession trough in output and investment by 41% and 28%, respectively. Theoretically, we show that a New-Keynesian model with endogenously time-varying risk aversion a la Campbell and Cochrane (1999) produces large falls in investment and equity prices and closely matches state-dependent data responses following positive uncertainty shocks. Finally, the model-implied conditional term structure of equity risk premium is pro-cyclical: upward sloping in good times and down sloping in bad times. This is largely consistent with the empirical stylized fact recently found in the literature.

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

JEL Classification: C32, C63, E32, E44