On the business cycle implications of alternative risk aversion formulations

Abstract

In this paper, I investigate the effects of alternative risk aversion formulations on business cycle properties of an otherwise standard real business cycle economy. I first report on the implications of different risk aversion formulations on impulse response functions of real variables, and show that when risk aversion coefficient co-moves counter-cyclically, responses of real variables vary sizeably due to additional wedges both in the intratemporal and the intertemporal margin. Next, I show that formulating the risk aversion coefficient as random walk instead of a deep structural parameter generates better fit with observed volatilities of real variables. Finally, I report that modelling risk aversion coefficient in an endogenously-driven counter-cyclical way improves match with data on real variable correlations. Keywords: Business cycle statistics, Real business cycles, Time-varying risk, Risk preferences, JEL Classifications: E30, E32, E37, E60, E71