Risk Premium Shocks Can Create Inefficient Recessions

This paper proposes a flexible-price model of business cycles driven by spikes in uninsurable idiosyncratic risk, built by adding one friction – entrepreneurs’ inability to insure the idiosyncratic risk in their own production – to an otherwise standard neoclassical growth model with workers and entrepreneurs. When aggregate shocks raise idiosyncratic risk, entrepreneurs demand a risk premium to compensate for bearing it, which shows up as a countercyclical wedge that effectively taxes both labour and capital; but because capital is a long-duration store of value, a concurrent precautionary-saving motive lowers interest rates and offsets the risk premium’s drag on investment demand, while labour, having no such store-of-value role, is left depressed by the risk premium alone. The paper derives a sufficient statistic showing that, calibrated to U.S. data, these two offsetting forces on capital roughly cancel, so risk shocks act almost purely as a tax on labour – generating recessions in which employment, consumption, and investment decline together, quantitatively broadly consistent with U.S. business-cycle facts. This competitive-equilibrium response is shown to be inefficient: because individual agents take interest rates and the market price of risk as given, they do not internalize that their own consumption choices affect aggregate idiosyncratic risk sharing, so a fall in aggregate consumption during a downturn worsens risk sharing and pushes risk premiums higher still, in a self-reinforcing spiral. A constrained-efficient planner who faces the same limits on idiosyncratic risk sharing responds very differently – lowering labour taxes and raising capital taxes during downturns, which stimulates employment and raises consumption on impact rather than letting it fall – so that optimal policy calls for subsidizing employment and consumption, not investment, during recessions.

Robert Hall | Macro Paper Warehouse

Risk Premium Shocks Can Create Inefficient Recessions