On the Effects of Rare Disasters and Uncertainty Shocks for Risk Premia in Non-Linear DSGE Models

Abstract

This paper studies how rare disasters and uncertainty shocks affect risk premia in DSGE models approximated 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 affect any type of risk premia in a wide class of DSGE models. To quantify the effects, we set up a standard New Keynesian DSGE model where total factor productivity includes rare disasters, stochastic volatility, and GARCH. We find that rare disasters increase the level of the 10-year nominal term premium, whereas a key effect of uncertainty shocks, i.e. stochastic volatility and GARCH, is an increase in the variability of this premium.