Idiosyncratic Production Risk, Growth and the Business Cycle.pdfVIP

Idiosyncratic Production Risk, Growth and the Business Cycle∗ George-Marios Angeletos Laurent-Emmanuel Calvet MIT and NBER Harvard and NBER This draft: October 2003 We introduce a neoclassical growth economy with idiosyncratic production risk and incomplete markets. Each agent is an entrepreneur operating her own neoclassical technology with her own capital stock. The general equilibrium is characterized in closed form. Idiosyncratic production shocks introduce a risk premium on private equity and reduce the demand for investment. The steady state is characterized by a lower capital stock due to investment risk and a lower interest rate due to precautionary savings as compared to complete markets. The anticipation of low savings and high real interest rates in the future feeds back into high risk premia and low investment in the present, thus slowing down convergence to the steady state. More generally, countercyclicality in private risk premia is identified as a source of amplification and persistence in the business cycle. Keywords: Entrepreneurial risk, Incomplete markets, Macroeconomic complemen- tarity, Investment, Growth, Fluctuations, Precautionary savings. JEL Classification: D5, D9, E3, O1. ∗Correspondence: 50 Memorial Drive, E52-251, Cambridge, MA 02142, angelet@; Littauer Center, Cambridge, MA 02138, laurent_calvet@. This manuscript is a thoroughly revised version of an earlier working paper, “Incomplete Markets, Growth and the Business Cycle”. We are especially grateful to Daron Acemoglu, Fernando Alvarez, Ricardo Caballero, and John Campbell for