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

Abstract

In order to develop a model that …ts both business cycles and asset pricing facts, this paper introduces a small, risk of economic disaster in an otherwise standard real business cycle model. This simple feature can generate large and volatile risk premia. Under some conditions, the risk of disaster does not aect the path of macroeconomic aggregates, but in general it does: there is no separation theorembetween quantities and prices (unlike Tallarini (2000)). 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 eect of time- varying beliefsor time-varying risk aversionon the macroeconomy. 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 di¢ cult to replicate in a standard model.