How Non-Gaussian Shocks Affect Risk Premia in Non-Linear DSGE Models

Abstract

This paper studies how non-Gaussian shocks aect risk premia in DSGE models approx- imated to second and third order. Based on an extension of the results in Schmitt-Grohe & Uribe (2004) to third order, we derive propositions for how rare disasters, stochastic volatility, and GARCH aect any risk premia in a wide class of DSGE models. To quantify these eects, we then set up a standard New Keynesian DSGE model where total factor productivity includes rare disasters, stochastic volatility, and GARCH. We …nd that rare disasters increase the mean level of the 10-year nominal term premium, whereas a key eect of stochastic volatility and GARCH is an increase in the variability of this premium.