Direction Générale Des Études Et Des Relations Internationales Disaster Risk and Preference Shifts in a New Keynesian Model Working Paper 614 Banque De France Working Paper 614 Banque De France Working Paper 614

In RBC models, " disaster risk shocks " reproduce countercyclical risk premia but generate an increase in consumption along the recession and asset price fall, through their effects on agents' preferences (Gourio, 2012). This paper offers a solution to this puzzle by developing a New Keynesian model with such a small but time-varying probability of " disaster ". We show that price stickiness, combined with an elasticity of intertemporal substitution smaller than unity, restores procyclical consumption and wages, while preserving countercyclical risk premia, in response to disaster risk shocks. The mechanism then provides a rationale for discount factor first-and second-moment (" uncertainty ") shocks. Working Papers reflect the opinions of the authors and do not necessarily express the views of the Banque de France or the Bank of Finland. This document is available on the Banque de France Website. Les Documents de travail reflètent les idées personnelles de leurs auteurs et n'expriment pas nécessairement la position de la Banque de France ou de la Banque de Finlande. Ce document est disponible sur le site internet de la Banque de France. financial crisis, risk premia increased significantly in advanced economies and central banks implemented various unconventional monetary policies in order to reduce them. However, generating realistic risk premia along with expected macroeconomic variations in response to shocks is particularly challenging in standard economic models. We show that incorporating a time-varying " disaster risk " in a New Keynesian model allows to reproduce countercyclical risk premia together with the expected co-movement of macroeconomic variables, in particular consumption, investment, and wages, along the recession. In that respect, we improve some of the macroeconomic predictions from real business cycle (RBC) analysis of disaster risk and generalize the mechanism into a policy-friendly framework. A central feature of our model relies on the likelihood that rare disasters hit the economy. Rare disasters are large adverse events associated with a low probability, such as great recessions, wars, terrorist attacks or natural catastrophes. They can lead to important declines in production, consumption, capital, or productivity. Rietz (1988) and Barro (2006) showed that accounting for these events can explain the high level of risk premia observed in the data, incompatible with previous standard asset pricing models (equity premium puzzle). Furthermore, Gabaix (2011), Gourio (2012), and Wachter (2013) developed dynamic models which allow the probability of disasters to be time-varying. In particular, Gourio (2012) introduced a small time-varying probability of …

[1]  Julien Pénasse,et al.  Measuring Macroeconomic Tail Risk , 2017, Journal of Financial Economics.

[2]  Jean-Paul Renne,et al.  National Natural Rates of Interest and the Single Monetary Policy in the Euro Area , 2016, Journal of Applied Econometrics.

[3]  Michael Peters,et al.  The Gains from Input Trade with Heterogeneous Importers , 2016, American Economic Journal: Macroeconomics.

[4]  Adrian Penalver.  Optimal Monitoring of Long-Term Loan Contracts , 2016 .

[5]  Sophie Guilloux-Nefussi.  Globalization, Market Structure and Inflation Dynamics , 2016, Journal of International Economics.

[6]  M. Bussière,et al.  Global Trade Flows: Revisiting the Exchange Rate Elasticities , 2016, Open Economies Review.

[7]  Mélika Ben Salem,et al.  Which Combination of Fiscal and External Imbalances to Determine the Long-Run Dynamics of Sovereign Bond Yields? , 2016 .

[8]  J. Idier,et al.  An Early Warning System for Macro-Prudential Policy in France , 2016 .

[9]  M. Mogliani,et al.  Rationality of Announcements, Business Cycle Asymmetry, and Predictability of Revisions. The Case of French GDP , 2016 .

[10]  Clément Malgouyres,et al.  The Impact of Chinese Import Competition on the Local Structure of Employment and Wages: Evidence from France , 2016 .

[11]  O. de Bandt,et al.  A DGSE Model to Assess the Post-Crisis Regulation of Universal Banks , 2016 .

[12]  Camille Hémet,et al.  Diversity and Employment Prospects: Neighbors Matter! , 2016 .

[13]  Wei Yang.  Intertemporal Substitution and Equity Premium , 2016 .

[14]  Jesús Fernández-Villaverde,et al.  Solution Methods for Models with Rare Disasters , 2016 .

[15]  E. Siriwardane.  The Probability of Rare Disasters: Estimation and Implications , 2015 .

[16]  Alfonso A. Irarrazabal,et al.  Time-Varying Disaster Risk Models: An Empirical Assessment of the Rietz-Barro Hypothesis , 2015 .

[17]  Jessica A. Wachter,et al.  Disaster Risk and its Implications for Asset Pricing , 2015 .

[18]  M. Eichenbaum,et al.  Long-Run Bulls and Bears , 2015 .

[19]  Jonas D. M. Fisher.  On the Structural Interpretation of the Smets-Wouters 'Risk Premium' Shock , 2014 .

[20]  Anamaria Nicolae,et al.  The Effect of the Financial Crisis on TFP Growth: A General Equilibrium Approach , 2014 .

[21]  Gauti B. Eggertsson,et al.  Can Structural Reforms Help Europe? , 2013 .

[22]  Dongho Song,et al.  Identifying Long-Run Risks: A Bayesian Mixed-Frequency Approach , 2013 .

[23]  N. Bloom,et al.  Does Uncertainty Reduce Growth? Using Disasters as Natural Experiments , 2013 .

[24]  Zuzana Irsova,et al.  Cross-Country Heterogeneity in Intertemporal Substitution , 2013 .

[25]  M. Brede.  Disaster Risk in a New Keynesian Model , 2013 .

[26]  Jumana Saleheen,et al.  UK Labour Productivity Since the Onset of the Crisis — An International and Historical Perspective , 2012 .

[27]  S. Leduc,et al.  Uncertainty Shocks Are Aggregate Demand Shocks , 2012 .

[28]  J. Lindé,et al.  Fiscal Consolidation in an Open Economy , 2012 .

[29]  Jesús Fernández-Villaverde,et al.  Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board , Washington , D . C . Computing DSGE Models with Recursive Preferences and Stochastic Volatility , 2012 .

[30]  Martin M. Andreasen.  On the Effects of Rare Disasters and Uncertainty Shocks for Risk Premia in Non-Linear DSGE Models , 2011 .

[31]  Brent H. Bundick,et al.  Uncertainty Shocks in a Model of Effective Demand , 2011 .

[32]  John H. Cochrane,et al.  Presidential Address: Discount Rates , 2011 .

[33]  John B. Lee,et al.  Time-Varying Rare Disaster Risk and Stock Returns , 2011 .

[34]  X. Gabaix.  Disasterization: A Simple Way to Fix the Asset Pricing Properties of Macroeconomic Models , 2011 .

[35]  François Gourio.  Credit Risk and Disaster Risk , 2011 .

[36]  R. Barro,et al.  Crises and Recoveries in an Empirical Model of Consumption Disasters , 2010 .

[37]  François Gourio.  Disaster Risk and Business Cycles , 2010 .

[38]  Ravi Bansal,et al.  An Empirical Evaluation of the Long-Run Risks Model for Asset Prices , 2009 .

[39]  Lawrence J. Christiano,et al.  When Is the Government Spending Multiplier Large? , 2009, Journal of Political Economy.

[40]  R. Barro,et al.  On the Size Distribution of Macroeconomic Disasters , 2009 .

[41]  John Y. Campbell,et al.  The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment , 2009, Critical Finance Review.

[42]  Glenn D. Rudebusch,et al.  The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks , 2008 .

[43]  Jessica A. Wachter,et al.  Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility? , 2008 .

[44]  R. Barro,et al.  Consumption Disasters in the Twentieth Century , 2008 .

[45]  X. Gabaix.  Variable Rare Disasters: A Tractable Theory of Ten Puzzles in Macro-finance , 2008 .

[46]  Xavier Gabaix,et al.  Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance , 2007 .

[47]  N. Bloom.  The Impact of Uncertainty Shocks , 2007 .

[48]  F. Smets,et al.  Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach , 2007 .

[49]  R. Barro.  Rare Disasters and Asset Markets in the Twentieth Century , 2006 .

[50]  Motohiro Yogo,et al.  Estimating the Elasticity of Intertemporal Substitution When Instruments Are Weak , 2003, Review of Economics and Statistics.

[51]  Gauti B. Eggertsson,et al.  Zero Bound on Interest Rates and Optimal Monetary Policy , 2003, Brookings Papers on Economic Activity.

[52]  Frank Smets,et al.  An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area , 2002 .

[53]  Annette Vissing-Jorgensen,et al.  Limited Asset Market Participation and the Elasticity of Intertemporal Substitution , 2002, Journal of Political Economy.

[54]  Ravi Bansal,et al.  Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles , 2000 .

[55]  Thomas D. Tallarini.  Risk-sensitive real business cycles☆ , 2000 .

[56]  Sydney C. Ludvigson,et al.  Consumption and Credit: A Model of Time-Varying Liquidity Constraints , 1999, Review of Economics and Statistics.

[57]  Costas Meghir,et al.  Consumer demand and the life-cycle allocation of household expenditures , 1993 .

[58]  O. Attanasio,et al.  Consumption Over the Life Cycle and Over the Business Cycle , 1993 .

[59]  Tamim A. Bayoumi.  Financial Deregulation and Consumption in the United Kingdom , 1993 .

[60]  John Y. Campbell,et al.  What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns , 1991 .

[61]  N. Mankiw,et al.  The Consumption of Stockholders and Non-Stockholders , 1990 .

[62]  P. Weil.  Nonexpected Utility in Macroeconomics , 1990 .

[63]  P. Weil.  The equity premium puzzle and the risk-free rate puzzle , 1989 .

[64]  John Y. Campbell,et al.  Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence , 1989, NBER Macroeconomics Annual.

[65]  Thomas A. Rietz.  The equity risk premium a solution , 1988 .

[66]  R. Mehra,et al.  THE EQUITY PREMIUM A Puzzle , 1985 .

[67]  John Y. Campbell,et al.  Bond and Stock Returns in a Simple Exchange Model , 1984 .

[68]  Agnar Sandmo,et al.  The Effect of Uncertainty on Saving Decisions , 1970 .

[69]  H. Leland..  Saving and Uncertainty: The Precautionary Demand for Saving , 1968 .

[70]  Disaster risk and preference shifts in a New Keynesian model , 2018 .

[71]  J. Mairesse,et al.  Labour market regulations and capital labour sustitution , 2017 .

[72]  Motohiro Yogo,et al.  Inspecting the Mechanism of Quantitative Easing in the Euro Area , 2019, Journal of Financial Economics.

[73]  Marc Joëts,et al.  Does the volatility of commodity prices reflect macroeconomic uncertainty ? Does the volatility of commodity prices reflect macroeconomic uncertainty ? , 2015 .