TY  - JOUR
AU  - Gourio,François
TI  - Disasters Risk and Business Cycles
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 15399
PY  - 2009
Y2  - October 2009
UR  - http://www.nber.org/papers/w15399
L1  - http://www.nber.org/papers/w15399.pdf
N1  - Author contact info:
Francois Gourio
Department of Economics
Boston University
270 Bay State Road
Boston, MA 02215
Tel: 617/353-4534
Fax: 617/353-4449
E-Mail: fgourio@bu.edu
AB  - To construct a business cycle model consistent with the observed behavior of asset prices, and study the effect of shocks to aggregate uncertainty, I introduce a small, time-varying risk of economic disaster in a standard real business cycle model. The paper establishes two simple theoretical results: first, when the probability of disaster is constant, the risk of disaster does not affect the path of macroeconomic aggregates - a "separation theorem" between macroeconomic quantities and asset prices in the spirit of Tallarini (2000). Second, shocks to the probability of disaster, which generate variation in risk premia over time, are observationally equivalent to preference shocks. An increase in the perceived probability of disaster leads to a collapse of investment and a recession, an increase in risk spreads, and a decrease in the yield on safe assets. To assess the empirical validity of the model, I infer the probability of disaster from observed asset prices and feed it into the model. The variation over time in this probability appears to account for a significant fraction of business cycle dynamics, especially sharp downturns in investment and output such as 2008-IV.
ER  -