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RISK SHOCKS, RISK MANAGEMENT, AND INVESTMENT

Published online by Cambridge University Press:  29 November 2019

Jonathan Goldberg
Jonathan Goldberg*
Affiliation:
Federal Reserve Board
*
Address correspondence to: Jonathan Goldberg, Federal Reserve Board, Mailstop K1-164, 20th Street and Constitution Avenue NW, Washington, DC20551, USA. e-mail: [email protected].
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Abstract

This paper studies the macroeconomic effects of shocks to idiosyncratic business risk in an economy with endogenously incomplete markets. I develop a model in which firms face idiosyncratic risk and obtain insurance from intermediaries through contracts akin to credit lines. Insurance is imperfect due to limited commitment in financial contracts. Although steady-state capital is higher than if firms were constrained to issue only standard equity, a rise in uncertainty about idiosyncratic business outcomes leads to an endogenous reduction in risk sharing. This deterioration in risk sharing results from a general-equilibrium shortage of pledgeable assets and implies that the economy’s response to an increase in idiosyncratic business risk can be amplified by financial contracting rather than dampened. In a parametrized version of the model, a rise in idiosyncratic business risk generates a large increase in uncertainty about aggregate investment.

Keywords

Endogenously Incomplete MarketsIdiosyncratic RiskAggregate Fluctuations
Type
Articles
Information
Macroeconomic Dynamics , Volume 25 , Issue 7 , October 2021 , pp. 1779 - 1809
Copyright
© Cambridge University Press 2019

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Footnotes

I am very grateful to two anonymous referees, Marios Angeletos, Nick Bloom, Ricardo Caballero, Giovanni Favara, Guido Lorenzoni, Anna Orlik, Vasia Panousi, Rebecca Wasyk, and Iván Werning for their helpful suggestions. I also would like to thank the seminar participants at ESEM 2017, Boston College, Boston University, the University of California-Berkeley (Haas), MIT, the University of Maryland (Smith), the University of Michigan, the World Bank, the Federal Reserve Banks of Kansas City, New York and Richmond, and conferences. I gratefully acknowledge the financial support from the Kauffman Foundation. The views expressed here are those of the author and need not represent the views of the Federal Reserve Board or its staff.

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