Disaster risk and preference shifts in a New Keynesian model

Isoré, Marlène and Szczerbowicz, Urszula (2015): Disaster risk and preference shifts in a New Keynesian model.

Abstract

This paper analyzes the effects of a change in a small but time-varying “disaster risk” à la Gourio (2012) in a New Keynesian model. In a real business cycle framework, the disaster risk has been successful in replicating observed moments of equity premia. However, responses of macroeconomic variables critically depend on the value of the elasticity of intertemporal substitution (EIS). In particular, we show here that an increase in the probability of disaster causes a recession only in case of an EIS larger than unity, which may be arbitrarily large. Nevertheless, we also find that incorporating sticky prices allows to conciliate recessionary effects of the disaster risk with a plausible value of the EIS. A higher disaster risk is then also associated with an increase in the discount factor and with deflation, making it consistent with the preference shock literature (Christiano et al., 2011).

• Item Type: MPRA Paper
• Language: English
• Keywords: disaster risk, rare events, uncertainty, asset pricing, DSGE models, New Keynesian models, business cycles
• Subjects: E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E20 - General; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E31 - Price Level ; Inflation ; Deflation; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q5 - Environmental Economics > Q54 - Climate ; Natural Disasters and Their Management ; Global Warming

References

[1] Martin Andreasen. On the Effects of Rare Disasters and Uncertainty Shocks for Risk Premia in Non-Linear DSGE Models. Review of Economic Dynamics, 15(3):295–316, July 2012.

[2] Orazio P. Attanasio and Martin Browning. Consumption over the Life Cycle and over the Business Cycle. American Economic Review, 85(5):1118–37, December 1995.

[3] Stéphane Auray, Aurélien Eyquem, and Frédéric Jouneau-Sion. Modeling tails of aggregate economic processes in a stochastic growth model. Computational Statistics & Data Analysis, 76(C):76–94, 2014.

[4] Scott R. Baker and Nicholas Bloom. Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments. NBER Working Papers 19475, National Bureau of Economic Research, Inc, September 2013.

[5] Ravi Bansal and Amir Yaron. Risks for the long run: A potential resolution of asset pricing puzzles. The Journal of Finance, 59(4):1481– 1509, 2004.

[6] Robert J. Barro. Rare disasters and asset markets in the twentieth century. Quarterly Journal of Economics, 2006.

[7] Robert J. Barro and Tao Jin. On the size distribution of macroeconomic disasters. Econometrica, 79(5):1567–1589, 2011.

[8] Robert J. Barro and Jose F. Ursúa. Consumption disasters in the twentieth century. The American Economic Review, pages 58–63, 2008.

[9] Susanto Basu and Brent Bundick. Uncertainty shocks in a model of effective demand. Research Working Paper RWP 14-15, Federal Reserve Bank of Kansas City, November 2014.

[10] Tamim A Bayoumi. Financial Deregulation and Consumption in the United Kingdom. The Review of Economics and Statistics, 75(3):536– 39, August 1993.

[11] Jason Beeler and John Y. Campbell. The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment. Critical Finance Review, 1(1):141–182, January 2012.

[12] Pierpaolo Benigno and Luigi Paciello. Monetary policy, doubts and asset prices. Journal of Monetary Economics, 64(C):85–98, 2014.

[13] Henk Berkman, Ben Jacobsen, and John B. Lee. Time-varying rare disaster risk and stock returns. Journal of Financial Economics, 101(2):313–332, August 2011.

[14] Ben S Bernanke. Irreversibility, Uncertainty, and Cyclical Investment. The Quarterly Journal of Economics, 98(1):85–106, February 1983.

[15] Nicholas Bloom. The Impact of Uncertainty Shocks. Econometrica, 77(3):623–685, 05 2009.

[16] Nicholas Bloom. Fluctuations in Uncertainty. Journal of Economic Perspectives, 28(2):153–76, 2014.

[17] Nicholas Bloom, Stephen Bond, and John Van Reenen. Uncertainty and Investment Dynamics. Review of Economic Studies, 74(2):391–415, 2007.

[18] Richard Blundell, Martin Browning, and Costas Meghir. Consumer Demand and the Life-Cycle Allocation of Household Expenditures. Review of Economic Studies, 61(1):57–80, January 1994.

[19] Dario Caldara, Jesus Fernández-Villaverde, Juan Rubio-Ramírez, and Wen Yao. Computing DSGE Models with Recursive Preferences and Stochastic Volatility. Review of Economic Dynamics, 15(2):188–206, April 2012.

[20] John Y Campbell. Bond and Stock Returns in a Simple Exchange Model. The Quarterly Journal of Economics, 101(4):785–803, November 1986.

[21] John Y. Campbell and John Ammer. What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns. The Journal of Finance, 48(1):3–37, 1993.

[22] John Y. Campbell and John Cochrane. Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior. Journal of Political Economy, 107(2):205–251, April 1999.

[23] John Y. Campbell and N. Gregory Mankiw. Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence. In NBER Macroeconomics Annual 1989, Volume 4, NBER Chapters, pages 185– 246. National Bureau of Economic Research, Inc, May 1989.

[24] Siddhartha Chib and Srikanth Ramamurthy. DSGE Models with Student- t Errors. Econometric Reviews, 33(1-4):152–171, June 2014.

[25] Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo. When Is the Government Spending Multiplier Large? Journal of Political Economy, 119(1):78 – 121, 2011.

[26] John H Cochrane. Presidential address: Discount rates. The Journal of Finance, 66(4):1047–1108, 2011.

[27] Vasco Cúrdia, Marco Del Negro, and Daniel L. Greenwald. Rare Shocks, Great Recessions. Journal of Applied Econometrics, 29(7):1031–1052, November 2014.

[28] Gauti B. Eggertsson, Andrea Ferrero, and Andrea Raffo. Can structural reforms help europe? Journal of Monetary Economics, 61:2–22, 2014.

[29] Gauti B. Eggertsson and Michael Woodford. The Zero Bound on Interest Rates and Optimal Monetary Policy. Brookings Papers on Economic Activity, 34(1):139–235, 2003.

[30] Larry G. Epstein and Stanley E. Zin. Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework. Econometrica, 57(4):937–69, July 1989.

[31] Christopher J. Erceg and Jesper Linde. Fiscal Consolidation in an Open Economy. American Economic Review, 102(3):186–91, May 2012.

[32] Jesús Fernández-Villaverde, Pablo Guerron-Quintana, Keith Kuester, and Juan Francisco Rubio-Ramírez. Fiscal Volatility Shocks and Economic Activity. Technical Report 8528, C.E.P.R. Discussion Papers, August 2011b.

[33] Jesús Fernández-Villaverde, Pablo Guerron-Quintana, Juan F. Rubio-Ramírez, and Martin Uribe. Risk Matters: The Real Effects of Volatility Shocks. American Economic Review, 101(6):2530–61, October 2011a.

[34] Xavier Gabaix. Variable Rare Disasters: A Tractable Theory of Ten Puzzles in Macro-finance. American Economic Review, 98(2):64–67, 2008.

[35] Xavier Gabaix. Disasterization: A Simple Way to Fix the Asset Pricing Properties of Macroeconomic Models. American Economic Review, 101(3):406–09, May 2011.

[36] Xavier Gabaix. Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance. The Quarterly Journal of Economics, 127(2):645–700, 2012.

[37] Xavier Gabaix and Matteo Maggiori. International Liquidity and Exchange Rate Dynamics. NBER Working Papers 19854, National Bureau of Economic Research, Inc, January 2014.

[38] François Gourio. Disasters and recoveries. American Economic Review, 98(2):68–73, May 2008.

[39] François Gourio. Disaster Risk and Business Cycles. American Economic Review, 102(6):2734–66, October 2012.

[40] François Gourio. Credit Risk and Disaster Risk. American Economic Journal: Macroeconomics, 5(3):1–34, July 2013.

[41] Robert E Hall. Intertemporal Substitution in Consumption. Journal of Political Economy, 96(2):339–57, April 1988.

[42] Richard Hartman. The effects of price and cost uncertainty on investment. Journal of Economic Theory, 5(2):258–266, October 1972.

[43] Tomas Havránek, Roman Horvath, Zuzana Irsova, and Marek Rusnak. Cross-country heterogeneity in intertemporal substitution. Journal of International Economics, 96(1):100–118, 2015.

[44] Abigail Hughes and Jumana Saleheen. UK labour productivity since the onset of the crisis ? an international and historical perspective. Bank of England Quarterly Bulletin, 52(2):138–146, 2012.

[45] Alfonso Irarrazabal and Juan Carlos Parra-Alvarez. Time-varying disaster risk models: An empirical assessment of the Rietz-Barro hypothesis. CREATES Research Papers 2015-08, School of Economics and Management, University of Aarhus, February 2015.

[46] Peter N. Ireland. Technology shocks in the new keynesian model. Review of Economics and Statistics, 86(4):923–936, 2004.

[47] Sylvain Leduc and Zheng Liu. Uncertainty Shocks are Aggregate Demand Shocks. Working Paper Series 2012-10, Federal Reserve Bank of San Francisco, 2012.

[48] Hayne E. Leland. Saving and Uncertainty: The Precautionary Demand for Saving. The Quarterly Journal of Economics, 82(3):465–473, August 1968.

[49] Sydney Ludvigson. Consumption And Credit: A Model Of Time- Varying Liquidity Constraints. The Review of Economics and Statistics, 81(3):434–447, August 1999.

[50] Gregory N. Mankiw and Stephen P. Zeldes. The Consumption of Stockholders and Nonstockholders. Journal of Financial Economics, 29(1):97–112, 1991.

[51] Robert McDonald and Daniel Siegel. The Value of Waiting to Invest. The Quarterly Journal of Economics, 101(4):707–27, November 1986.

[52] Rajnish Mehra and Edward C. Prescott. The equity premium: A puzzle. Journal of monetary Economics, 15(2):145–161, 1985.

[53] Stephen Millard and Anamaria Nicolae. The effect of the financial crisis on TFP growth: a general equilibrium approach. Bank of England working papers 502, Bank of England, June 2014.

[54] Emi Nakamura, Jón Steinsson, Robert J. Barro, and José Ursúa. Crises and Recoveries in an Empirical Model of Consumption Disasters. American Economic Journal: Macroeconomics, 5(3):35–74, July 2013.

[55] Anna Pavlova and Roberto Rigobon. Asset Prices and Exchange Rates. Review of Financial Studies, 20(4):1139–1180, 2007.

[56] Monika Piazzesi, Martin Schneider, and Selale Tuzel. Housing, consumption and asset pricing. Journal of Financial Economics, 83(3):531–569, March 2007.

[57] Thomas A. Rietz. The equity risk premium: a solution. Journal of Monetary Economics, 22(1):117–131, July 1988.

[58] Glenn D. Rudebusch and Eric T. Swanson. The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks. American Economic Journal: Macroeconomics, 4(1):105–43, January 2012.

[59] Enrico Saltari and Davide Ticchi. Risk aversion, intertemporal substitution, and the aggregate investment-uncertainty relationship. Journal of Monetary Economics, 54(3):622–648, April 2007.

[60] Agnar Sandmo. The Effect of Uncertainty on Saving Decisions. Review of Economic Studies, 37(3):353–60, July 1970.

[61] Frank Schorfheide, Dongho Song, and Amir Yaron. Identifying Long-Run Risks: A Bayesian Mixed-Frequency Approach. NBER Working Papers 20303, National Bureau of Economic Research, Inc, July 2014.

[62] Sang Byung Seo and Jessica A. Wachter. Option Prices in a Model with Stochastic Disaster Risk. NBER Working Papers 19611, National Bureau of Economic Research, Inc, November 2013.

[63] Frank Smets and Rafael Wouters. An Estimated Dynamic Stochastic General Equilibrium Model of the EURO Area. Journal of the European Economic Association, 1(5):1123–1175, 09 2003.

[64] Frank Smets and Rafael Wouters. Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach. American Economic Review, 97(3):586–606, 2007.

[65] Thomas D. Tallarini Jr. Risk-sensitive real business cycles. Journal of Monetary Economics, 45(3):507–532, June 2000.

[66] Linda L. Tesar and Alan C. Stockman. Tastes and technology in a two-country model of the business cycle: Explaining international. American Economic Review, 85(1):168–185, 1995.

[67] Jerry Tsai and Jessica A. Wachter. Disaster Risk and its Implications for Asset Pricing. NBER Working Papers 20926, National Bureau of Economic Research, Inc, February 2015.

[68] Annette Vissing-Jorgensen. Limited Asset Market Participation and the Elasticity of Intertemporal Substitution. Journal of Political Economy, 110(4):825–853, August 2002.

[69] Jessica A. Wachter. Can time-varying risk of rare disasters explain aggregate stock market volatility? The Journal of Finance, 68(3):987– 1035, 2013.

[70] Philippe Weil. The equity premium puzzle and the risk-free rate puzzle. Journal of Monetary Economics, 24(3):401–421, November 1989.

[71] Philippe Weil. Nonexpected utility in macroeconomics. Quarterly Journal of Economics, 105(1):29–42, February 1990.

[72] Martin L. Weitzman. Rare Disasters, Tail-Hedged Investments, and Risk-Adjusted Discount Rates. NBER Working Papers 18496, National Bureau of Economic Research, Inc, October 2012.

[73] Motohiro Yogo. Estimating the elasticity of intertemporal substitution when instruments are weak. Review of Economics and Statistics, 86(3):797–810, 2004.

[74] Joseph Zeira. Cost uncertainty and the rate of investment. Journal of Economic Dynamics and Control, 14(1):53–63, February 1990.