Relationship between risk attitude and economic recovery in optimal growth theory

Abstract

Policy makers often resort to Keynesian fiscal stimulus to try to stabilize the economy after a major economic downturn. This is nearly always financed with deficit spending and thus debt (under the rubric of quantitative easing11Some note that “quantitative easing” is a modern euphemism formerly called “monetizing the debt.”) which invariably leads to huge budget deficit problems that tend to weaken investor and consumer confidence. Many economists agree it is better to let the economy grow out of the downturn than to finance further deficit spending through increased taxation or by printing money. Economic growth increases employment and generates government revenues to help balance the budget. But policies promoting economic growth often neglect the attitudes of consumers and investors towards risks. Risk-attitude is especially relevant if the shock originates from the financial sector, causing uncertainty and distrust. This paper examines the effect of risk aversion on growth recovery after an economic shock. We find that within the framework of optimal growth theory, risk-attitude determines the strength of the recovery path. We also find that risk-attitude can undermine the effectiveness of low interest rate policies. This highlights the importance of having policies geared towards restoring a stable risk-attitude in the economy. We feel results can best be achieved by resorting more to market mechanisms and less to government intervention. Market transparency and market discipline should be promoted to add certainty and trust so that people can properly form their risk-attitude.