Risk Premium Shocks Can Create Inefficient Recessions
We develop an equilibrium theory of business cycles driven by spikes in risk premiums that depress business demand for capital and labor. Aggregate shocks increase firms’ uninsurable idiosyncratic risk and raise risk premiums. We show that risk shocks can create quantitatively realistic recessions, with contractions in employment, consumption, and investment. Business cycles are inefficient—output and employment fall too much during recessions, compared to the constrained-efficient allocation, and consumption should rise. Optimal policy involves stimulating employment and consumption during recessions.
Hall’s research is supported by the Hoover Institution. We thank Chris Tonetti, Chad Jones, Emmanuel Farhi, Tom Winberry, Alp Simsek, Moritz Lenel, Rohan Kekre, and seminar participants in Princeton, LSE, Fed Board, AEA meetings, and Cleveland Fed. We thank Bernard Herskovic, Bryan Kelly, Hanno Lustig, and Stijn Van Nieuwerburgh for sharing their data with us. Neither author has any financial relationships calling for disclosure. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Robert E. Hall
Hall attends conferences and meetings at the Federal Reserve Board and regional Federal Reserve Banks, at the European Central Bank, and at the central banks of other countries, including the United Kingdom, Portugal, Chile, and Canada. In some cases, he receives honorariums for his participation. His wife, Susan Woodward, has similar relations with the Federal Reserve System. His daughter is an economist at the US Treasury. His son is chief economist of Uber Technologies, Inc. Hall's research is supported by Stanford's Hoover Institution.
Sebastian Di Tella & Robert Hall, 2022. "Risk Premium Shocks Can Create Inefficient Recessions," The Review of Economic Studies, vol 89(3), pages 1335-1369.