XXV Edition

1-2 December 2016"

Disaster Risk and Preference Shifts in a New Keynesian Model

Isoré Marlène, University of Helsinki and Bank of Finland
Szczerbowicz Urszula, Bank of France

This paper analyzes the effects of a change in a small but time-varying "disaster risk" à la Gourio (2012) in a New Keynesian model. Real business cycle models featuring disaster risk have been successful in replicating observed moments of equity premia, yet their macroeconomic responses are highly sensitive to the chosen value of the elasticity of intertemporal substitution (EIS). In particular, we show here that an increase in the probability of disaster causes a recession only when imposing an EIS larger than unity, which may be arbitrarily large. Nevertheless, we also nd that incorporating sticky prices allows to conciliate recessionary effects of the disaster risk with a plausible value of the EIS. The disaster risk shock causes endogenous shifts in preferences which provide a rationale for discount factor first- (Christiano et al., 2011) and second- (Basu and Bundick, 2014) moment shocks.

Area: Monetary Policy and Central Banking

Keywords: Disaster risk, Rare events, Uncertainty, Asset pricing, DSGE models, New Keynesian models, Business cycles

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