Response of the Macroeconomy to Uncertainty Shocks:the Risk Premium Channel

Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty not only increases risk, but it also elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant risk premia in bad times, which in turn exacerbate the decline of macroeconomic aggregates and equity prices. Empirically, we document that local projection coefficients capturing the data response to the interaction of risk aversion and uncertainty are statistically significant and economically large. Indeed, heightened levels of RA during the 2008 crisis amplified the drop in output and investment by 41% and 28%, respectively, at the recession trough. Theoretically, we show that a New-Keynesian model with endogenously time-varying risk aversion via Campbell and Cochrane (1999) can produce large falls in output and investment close to matching their data counterparts following positive uncertainty shocks.