Another risk-based model of business cycles

I say if you don’t understand risk-based models, it is difficult to grasp why recovery has been so slow, or why the cycle was so tough to begin with.  Here is Mete Kilic, Jessica A. Wachter:

What is the driving force behind the cyclical behavior of unemployment and vacancies? What is the relation between job creation incentives of firms and stock market valuations? This paper proposes an explanation of labor market volatility based on time-varying risk, modeled as a small and variable probability of an economic disaster. A high probability of a disaster implies greater risk and lower future growth, which lowers the incentives of firms to invest in hiring. During periods of high disaster risk, stock market valuations are low and unemployment rises. The risk of a disaster generates a realistic equity premium, while time- variation in the disaster probability generates the correct magnitude for volatility in vacancies and unemployment. The model can thus explain the comovement of unemployment and stock market valuations present in the data.

That is a new NBER working paper.


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