Disaster Risk and Preference Shifts in a New Keynesian Model

Marlene Isore, Urszula Szczerbowicz

Research output: Working paperScientific

Abstract

In RBC models, “disaster risk shocks” reproduce countercyclical risk premia but generate an increase in consumption along the recession and asset price fall, through their effects on agents’ preferences (Gourio, 2012). This paper offers a solution to this puzzle by developing a New Keynesian model with such a small but time-varying probability of “disaster”. We show that price stickiness, combined with an elasticity of intertemporal substitution smaller than unity, restores procyclical consumption and wages, while preserving countercyclical risk premia, in response to disaster risk shocks. The mechanism then provides a rationale for discount factor first- and second-moment (“uncertainty”) shocks.
Original languageEnglish
Place of PublicationParis
PublisherBanque de France
Volume614
Number of pages59
Publication statusPublished - 2016
MoE publication typeD4 Published development or research report or study

Fields of Science

  • 511 Economics

Cite this

Isore, M., & Szczerbowicz, U. (2016). Disaster Risk and Preference Shifts in a New Keynesian Model. (Banque de France working papers). Paris: Banque de France.