Time-Varying Risk of Disaster, Time-Varying Risk Premia, and Macroeconomic Dynamics

Download or read book Time-Varying Risk of Disaster, Time-Varying Risk Premia, and Macroeconomic Dynamics written by Francois Gourio and published by . This book was released on 2009 with total page 42 pages. Available in PDF, EPUB and Kindle. Book excerpt: In order to develop a model that its both business cycles and asset pricing facts, this paper introduces a small, time-varying risk of economic disaster in an otherwise standard real business cycle model. This simple feature can generate large and volatile risk premia. The paper establishes two simple theoretical results: first, under some conditions, when the probability of disaster is constant, the risk of disaster does not affect the path of macroeconomic aggregates - a quot;separation theoremquot; between quantities and asset prices in the spirit of Tallarini (2000). Second, shocks to the probability of disaster, which generate variation in risk premia over time, are observationaly equivalent to preference shocks, and thus have a significant effect on macroeconomic aggregates: an increase in the perceived probability of disaster can lead to a collapse of investment and a recession, with no current or future change in productivity. This model thus allows to analyze the effect of a shock to quot;risk aversionquot; or a shock to beliefs on the macroeconomy (e.g. Fall 2008). Interestingly, this model is, at least qualitatively, consistent with the well-known facts that the stock market, the yield curve, and the short rate predict GDP growth, facts which are difficult to replicate in a standard model.