On the Size Distribution of Macroeconomic Disasters

Robert Barro and Tao Jin ()
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Tao Jin: Dept. of Economics, Harvard University

No 634, CEMA Working Papers from China Economics and Management Academy, Central University of Finance and Economics

Abstract: The coefficient of relative risk aversion is a key parameter for analyses of behavior toward risk, but good estimates of this parameter do not exist. A promising place for reliable estimation is rare macroeconomic disasters, which have a major influence on the equity premium. The premium depends on the probability and size distribution of disasters, gauged by proportionate declines in per capita consumption or gross domestic product. Long-term national-accounts data for 36 countries provide a large sample of disasters of magnitude 10% or more. A power-law density provides a good fit to the size distribution, and the upper-tail exponent, α, is estimated to be around 4. A higher α signifies a thinner tail and, therefore, a lower equity premium, whereas a higher coefficient of relative risk aversion, γ, implies a higher premium. The premium is finite if α > γ. The observed premium of 5% generates an estimated γ close to 3, with a 95% confidence interval of 2 to 4. The results are robust to uncertainty about the values of the disaster probability and the equity premium, and can accommodate seemingly paradoxical situations in which the equity premium may appear to be infinite.

Keywords: Power law; rare disaster; equity premium; risk aversion (search for similar items in EconPapers)
Pages: 23 pages
Date: 2023
New Economics Papers: this item is included in nep-rmg and nep-upt
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Related works:
Journal Article: On the Size Distribution of Macroeconomic Disasters (2011)
Working Paper: On the Size Distribution of Macroeconomic Disasters (2009)
Working Paper: On the Size Distribution of Macroeconomic Disasters
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Persistent link: https://EconPapers.repec.org/RePEc:cuf:wpaper:634

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