Disaster risk and business cycles

Motivated by the evidence that risk premia are large and countercyclical, this paper studies a tractable real business cycle model with a small, exogenously time-varying risk of disaster. Disaster risk a¤ects both asset prices and macroeconomic quantities. An increase in disaster risk leads to a decline of output, investment, stock prices, and interest rates, and an increase in the expected return on risky assets. The model matches well data on quantities, asset prices, and the relations between quantities and prices. Empirically, shocks to disaster risk, or more generally shocks to risk premia, play a signi\u85cant role in investment dynamics