Risk Premium Shocks Can Create Inefficient Recessions

Sebastian Di Tella and Robert Hall ()

No 26721, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: 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.

JEL-codes: E21 E22 E32 (search for similar items in EconPapers)
Date: 2020-01
New Economics Papers: this item is included in nep-dge and nep-mac
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Published as Sebastian Di Tella & Robert Hall, 2022. "Risk Premium Shocks Can Create Inefficient Recessions," The Review of Economic Studies, vol 89(3), pages 1335-1369.

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