A DSGE Model of Downside Risk

Luciano de Castro, Antonio Galvao and David Hong

Review of Economic Dynamics, 2026, vol. 61

Abstract: This paper develops a DSGE model with recursive quantile preferences and rare disaster risk. In this economy, infinitely lived households maximize the discounted value of the stream of future τ-quantile utilities for τ ∈ (0, 1). The quantile parameter τ captures the households’ downside risk attitude, independent of the elasticity of intertemporal substitution. We establish central properties of the model, including: (i) existence and uniqueness of a fixed point for household value functions, (ii) envelope condition, and the quantile Euler equation. We define the quantile recursive competitive equilibrium and establish its existence and uniqueness. Quantitatively, following a one-standard-deviation positive technology shock, output, consumption, and investment increase on impact and gradually return to baseline. In contrast, labor adjusts differently under recursive quantile preferences: initial labor hours decline, indicating that a preference-based tilt toward downside outcomes alters intratemporal tradeoffs even in an otherwise frictionless setting. Similar qualitative responses arise following rare-disaster shocks (Copyright: Elsevier)

Keywords: general equilibrium; business cycle; downside risk; recursive quantile preferences; quantile impulse response function (search for similar items in EconPapers)
JEL-codes: C63 D51 E32 (search for similar items in EconPapers)
Date: 2026
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DOI: 10.1016/j.red.2026.101352

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