Response of the Macroeconomy to Uncertainty Shocks: The Risk Premium Channel

62 Pages Posted: 22 Mar 2017 Last revised: 31 May 2019

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

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick; London School of Economics & Political Science (LSE)

Date Written: March 26, 2019

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

Suggested Citation

Bretscher, Lorenzo and Hsu, Alex and Tamoni, Andrea, Response of the Macroeconomy to Uncertainty Shocks: The Risk Premium Channel (March 26, 2019). 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)

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick ( email )

1 Washington Park
Newark, NJ 07102
United States

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

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

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