RISK SHOCKS, RISK MANAGEMENT, AND INVESTMENT

Jonathan Goldberg

Macroeconomic Dynamics, 2021, vol. 25, issue 7, 1779-1809

Abstract: This paper studies the macroeconomic effects of shocks to idiosyncratic business risk in an economy with endogenously incomplete markets. I develop a model in which firms face idiosyncratic risk and obtain insurance from intermediaries through contracts akin to credit lines. Insurance is imperfect due to limited commitment in financial contracts. Although steady-state capital is higher than if firms were constrained to issue only standard equity, a rise in uncertainty about idiosyncratic business outcomes leads to an endogenous reduction in risk sharing. This deterioration in risk sharing results from a general-equilibrium shortage of pledgeable assets and implies that the economy’s response to an increase in idiosyncratic business risk can be amplified by financial contracting rather than dampened. In a parametrized version of the model, a rise in idiosyncratic business risk generates a large increase in uncertainty about aggregate investment.

Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:cup:macdyn:v:25:y:2021:i:7:p:1779-1809_6

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