We investigate the eff ect of aggregate uncertainty shocks on real variables. More speci fically, we introduce a shock in the volatility of productivity in an RBC model with long-run volatility risk and preferences that exhibit generalised disappointment aversion. We find that, when combined with a negative productivity shock, a volatility shock leads to further decline in real variables, such as output, consumption, hours worked and investment. For instance, out of the 2% decrease in output as a result of both shocks, we attribute 0.25% to the e ffect of an increase in volatility. We also fi nd that this e ffect is the same as the one obtained in a model with Epstein-Zin- Weil preferences, but higher than that of a model with expected utility. Moreover, GDA preferences yield superior asset pricing results, when compared to both Epstein-Zin-Weil preferences and expected utility.

Thesis (Ph. D.)--University of Rochester. William E. Simon Graduate School of Business Administration, 2008.; The first chapter presents a simple real options model that explains why in cross-section high idiosyncratic volatility implies low future returns and why the value effect is stronger for high volatility firms. In the model, high idiosyncratic volatility makes growth options a hedge against aggregate volatility risk. Growth options become less sensitive to the underlying asset value as idiosyncratic volatility goes up. It cuts their betas and saves them from losses in volatile times that are usually recessions. Growth options value also positively depends on volatility. It makes them a natural hedge against volatility increases. In empirical tests, the aggregate volatility risk factor explains the idiosyncratic volatility discount and why it is stronger for growth firms. The aggregate volatility risk factor also partly explains the stronger value effect for high volatility firms. I also find that high volatility and growth firms have much lower betas in recessions than in booms. In the second chapter I show that the aggregate volatility risk factor (the BVIX factor) explains the well-known underperformance of small growth firms. The BVIX factor also reduces the underperformance of IPOs and SEOs by 45% and makes it statistically insignificant. The BVIX factor is unrelated to the investment factor proposed by Lyandres...

Why are emerging economies excessively vulnerable to shocks to external funding? What was the role of financial flows from emerging to developed economies in setting the stage for the subprime crisis? This paper addresses these questions in a simple general equilibrium framework that emphasizes the aggregate implications of the misallocation of funds on the micro level. The analysis shows that the misallocation of funds amplifies volatility even in a closed economy. Financial integration between relatively distorted emerging economies and relatively undistorted developed economies leads to a further divergence in volatility, thereby providing a new and simple explanation for the divergent trends in output volatility up to the recent crisis. In the integrated environment, cheap funding leads to an endogenous deterioration of the financial system in developed economies. These predictions are consistent with a wide variety of microfoundations, in which distortions cause productive projects to be relatively more sensitive to aggregate shocks. The paper provides some empirical evidence for these microfoundations.

In contrast with a growing literature on the drivers of aggregate volatility in developing countries, its consequences in terms of individual incomes have received less attention. This paper looks at the impact of cyclical output fluctuations and extreme output events (crises) on unemployment, poverty, and inequality. The authors find robust evidence that aggregate volatility has a regressive, asymmetric, and non linear impact, as reflected in the strong influence of extreme output drops. The findings show that, in addition to the mitigating role of personal wealth, public expenditure and labor protection exert a similar benign effect. These findings are in line with the income substitutions view of social safety nets, and cast a new light on the value of social programs and labor market regulation in crisis prone developing countries.

Climate models generally indicate that climate volatility may rise in the future, severely affecting agricultural productivity through greater frequency of yield-diminishing climate extremes, such as droughts. For Tanzania, where agricultural production is sensitive to climate, changes in climate volatility could have significant implications for poverty. This study assesses the vulnerability of Tanzania s population to poverty to changes in climate variability between the late 20th century and early this century. Future climate scenarios with the largest increases in climate volatility are projected to make Tanzanians increasingly vulnerable to poverty through its impacts on the production of staple grains, with as many as 90,000 additional people, representing 0.26 percent of the population, entering poverty in the median case. Extreme poverty-increasing outcomes are also found to be greater in the future under certain climate scenarios. In the 20th century, the greatest predicted increase in poverty was equal to 880...

This report uses an analytical framework that take into account the effect of natural disasters as well as country size in measuring the serious implications macroeconomic or aggregate volatility (marked period-to-period variations in measures of macroeconomic performance, such as GDP growth) has for individuals and households in Caribbean countries. The report is organized as follows: Chapter 1 reviews the recent economic and social development of the Caribbean. Chapter 2 begins by characterizing volatility of aggregate income and consumption growth and by employing regression analysis to assess the relative importance of the different factors that would be expected to determine macroeconomic volatility in the Caribbean. The chapter also examines factors that might be expected to influence the extent to which macroeconomic volatility is absorbed or amplified-that is, the extent of financial market development, the behavior of remittances, and the size and volatility of external capital flows. Chapter 3 addresses the broad question of how macroeconomic volatility in the Caribbean affects households and their income and consumption...

This paper examines the conceptual foundations of macroprudential policy by reviewing the literature on financial frictions from a policy perspective that systematically links state interventions to market failures. The method consists in gradually incorporating into the Arrow-Debreu world a variety of frictions and sources of aggregate volatility and combining them along three basic dimensions: purely idiosyncratic vs. aggregate volatility, full vs. bounded rationality, and internalized vs. uninternalized externalities. The analysis thereby obtains eight "domains," four of which include aggregate volatility, hence call for macroprudential policy variants grounded on largely orthogonal rationales. Two of them emerge even assuming that externalities are internalized: one aims at offsetting the public moral hazard implications of (efficient but time inconsistent) post-crisis policy interventions, the other at maintaining principal-agent incentives continuously aligned along the cycle. Allowing for uninternalized externalities justifies two additional types of macroprudential policy...

The author provides evidence of a causal and economically important effect of financial development on volatility. In contrast to the existing literature, the identification strategy is based on the differences in sensitivities to financial conditions across industries. The results show that sectors with larger liquidity needs are more volatile and experience deeper crises in financially underdeveloped countries. At the macroeconomic level, the results suggest that changes in financial development can generate important differences in aggregate volatility. The author also finds that financially underdeveloped countries partially protect themselves from volatility by concentrating less output in sectors with large liquidity needs. Nevertheless, this insulation mechanism seems to be insufficient to reverse the effects of financial underdevelopment on within-sector volatility. Finally, the author provides new evidence that: 1) Financial development affects volatility mainly through the intensive margin (output per firm). 2) Both the quality of information generated by firms...

Countries with more developed financial sectors, experience fewer fluctuations in real per capita output, consumption, and investment growth. But the manner in which the financial sector develops matters. The relative importance of banks in the financial system is important in explaining consumption, and investment volatility. The proportion of credit provided to the private sector, best explains volatility of consumption, and output. The authors generate their main results using fixed-effects estimates with panel data from seventy countries for the years 1956-98. Their general findings suggest that the risk management, and information processing provided by banks, maybe especially important in reducing consumption, and investment volatility. The simple availability of credit to the private sector, probably helps smooth consumption, and GDP.

This supplementary volume of the study on Growth Volatility in Paraguay—Sources, Effects, and Options provides a number of background papers and material that was prepared as part of this study. The topics are closely linked with the overarching story telling presented in the first volume of the report. 1) Business Cycles Accounting for Paraguay, by Viktoria Hnatkovska and Friederike (Fritzi) Koehler-Geib. 2) Agricultural Performance and Macroeconomic Outcomes in Paraguay, by Hakan Berument. 3) Paraguayan Agricultural and Macroeconomic Performance: A Wavelet Approach, by Hakan Berument. 4) A study of the Volatility of the Agricultural GDP in Paraguay and its impact in the Rest of the Economy, by Dionisio Borda, Franchesco Anichini, and Julio Ramirez.

This dissertation is concerned with the empirical determinants of urban growth in developed countries, and the effects of macroeconomic volatility in less developed countries, on urbanization and long run income growth. Four chapters are presented. Chapters 2 and 3 deal with urban population growth in the USA and employment growth in Germany. In both cases metropolitan areas grow faster if the initial concentration of highly skilled workers is higher. Chapter 2 looks at which city characteristics lead some cities to attract more skilled workers than others, resulting in a diverging pattern of skill concentration among cities. The chapter shows that this is not a selfreinforcing process. One of the more robust findings is that a personal services sector is a positive amenity. The number of skilled workers is expected to increase faster in metropolitan areas where this sector is abundant. The personal services sector is intensive in low-skilled labor which gives a new sound to the popular belief that only a highly-skilled culture sector will attract more skilled workers. The second chapter shows that divergence of the concentration of skills and its effect on metropolitan growth is very similar in Germany. It also shows that there may be positive interaction effects between similar but different skill levels. For example...

The level of urbanization has increased by over 5 percentage points per decade outside the developed world since 1960. Rapid urbanization was accompanied by fast economic growth and job creation in most parts of the world. However, notably Africa (and Latin America after 1980) has had a different experience: while growth in GDP per capita slowed significantly or even reversed, the rate of urbanization continued its fast pace. This paper aims to explain this by introducing an aggregate risk differential between the countryside and the city. Uninsurable expected risk will lead to rural-urban migration as a form of ex-ante insurance if households are liquidity constrained in incomplete markets and cannot overcome adverse shocks. Macroeconomic volatility finds its origins in risk-prone natural resource production including agriculture and has a robust positive effect on urban growth, especially when economic growth is slow. The effect stands up to the transitional view on urbanization of economies shifting from an agricultural to an industrial base.

In an otherwise unique-equilibrium model, agents are segmented into a few informational islands according to the signal they receive about others' expectations. Even if agents perfectly observe fundamentals, rational-exuberance equilibria (REX) can arise as they put weight on expectational signals to refine their forecasts. Constant-gain adaptive learning can trigger jumps between the equilibrium where only fundamentals are weighted and a REX. This determines regime switching in aggregate volatility despite unchanged monetary policy and time-invariant distribution of exogenous shocks. In this context, a thigh inflation-targeting policy can lower expectational complementarity preventing rational exuberance, although its effect is non-monotone.

When credit is constrained, a bias toward short-term debt can arise in financing long-term investments, generating maturity mismatches and leading potentially to liquidity crises. After the financial crises of the 1990s many voices rose to explain that the causes of these crises were new (Radelet and Sachs 1998; Corsetti, Pesenti, and Roubini 1999). According to the first, "crony capitalism" can explain the imbalances (Krugman 1999), because in distorting individual incentives, it encouraged firms to make inefficient decisions (about investments, risks, and so on). Understanding how economic and financial development modifies financial contracts requires understanding original sin. THE MACROECONOMIC MOD EL This section introduces this capital market framework in a macroeconomic model to shed light on the aggregate consequences of the structure of financial contracts. Long-term contracts are imperfectly enforceable; default is possible, but an entrepreneur needs to pay a marginal cost on the final output (t when the entrepreneur can carry out an illiquid long-term project and t when the entrepreneur violates the illiquidity constraint and reinvests in the storage technology). The case where entrepreneurs pay for their debts if and only if they can carry out their illiquid project until maturity (not considered here) is always dominated; entrepreneurs have to pay for default costs and there are no benefits for the debt portfolio (size being identical and risk premium being actuarially fair). These two sources of aggregate volatility reduce growth through independent channels; the probability of a run reduces the average return on the entrepreneur's projects...

A long empirical literature has examined the idea that, in the absence of hedging mechanisms, currency risk should have an adverse effect on the export volumes of risk averse exporters. But there are no clear conclusions from this literature, and the current consensus seems to be that there is at most a weak negative effect of exchange rate volatility on aggregate trade flows. However, most of this literature examines the impact of exchange rate volatility on aggregate trade flows, implicitly assuming a uniform impact of this volatility on exporters across sectors. This paper explots the fact that, if exchange rate volatility is detrimental for trade, firms exporting goods that offer a natural hedge against exchange rate fluctuations -- i.e. those whose international price is negatively correlated with the nominal exchange rate of the country where they operate -- should be relatively benefited in environments of high exchange rate volatility, and capture a larger share of the country's export basket. This hypothesis is tested using detailed data on the composition of trade of 132 countries at 4-digit SITC level. The results show that the commodities that offer natural hedge capture a larger share of a country's export basket when the exchange rate is volatile...

This paper documents and discusses a dramatic change in the cyclical behavior of aggregate hours worked by individuals with a college degree (skilled workers) since the mid-1980’s. Using the CPS outgoing rotation data set for the period 1979:1-2003:4, we find that the volatility of aggregate skilled hours relative to the volatility of GDP has nearly tripled since 1984. In contrast, the cyclical properties of unskilled hours have remained essentially unchanged. We evaluate the extent to which a simple supply/demand model for skilled and unskilled labor with capital-skill complementarity in production can help explain this stylized fact. Within this framework, we identify three effects which would lead to an increase in the relative volatility of skilled hours: (i) a reduction in the degree of capital-skill complementarity, (ii) a reduction in the absolute volatility of GDP (and unskilled hours), and (iii) an increase in the level of capital equipment relative to skilled labor. We provide empirical evidence in support of each of these effects. Our conclusion is that these three mechanisms can jointly explain about sixty percent of the observed increase in the relative volatility of skilled labor. The reduction in the degree of capital-skill complementarity contributes the most to this result.

This paper proposes an empirical test of financial contagion in European equity markets during the tumultuous period of 2008-2011. Our analysis shows that traditional GARCH and Gaussian stochastic-volatility models are unable to explain two key stylized features of global markets during presumptive contagion periods: shocks to aggregate market volatility can be sudden and explosive, and they are associated with specific directional biases in the cross-section of country-level returns. Our model repairs this deficit by assuming that the random shocks to volatility are heavy-tailed and correlated cross-sectionally, both with each other and with returns. The fundamental conclusion of our analysis is that great care is needed in modeling volatility if one wishes to characterize the relationship between volatility and contagion that is predicted by economic theory. In analyzing daily data, we find evidence for significant contagion effects during the major EU crisis periods of May 2010 and August 2011, where contagion is defined as excess correlation in the residuals from a factor model incorporating global and regional market risk factors. Some of this excess correlation can be explained by quantifying the impact of shocks to aggregate volatility in the cross-section of expected returns - but only...

We study a dynamical model of interconnected firms which allows for certain market imperfections and frictions, restricted here to be myopic price forecasts and slow adjustment of production. Whereas the standard rational equilibrium is still formally a stationary solution of the dynamics, we show that this equilibrium becomes linearly unstable in a whole region of parameter space. When agents attempt to reach the optimal production target too quickly, coordination breaks down and the dynamics becomes chaotic. In the unstable, "turbulent" phase, the aggregate volatility of the total output remains substantial even when the amplitude of idiosyncratic shocks goes to zero or when the size of the economy becomes large. In other words, crises become endogenous. This suggests an interesting resolution of the "small shocks, large business cycles" puzzle.

This thesis considers two interrelated themes: the emergence of aggregate volatility from idiosyncratic shocks and optimisation under incomplete information when, for reasons of strategic complementarity, agents are interested in both simple and weighted averages of their competitors' actions. I first develop a model of Bayesian social learning over a network. Unlike earlier literature that abandons one of the assumptions that agents (a) act repeatedly; (b) are rational; and (c) face strategic complementarities, I obtain tractability for arbitrarily large networks by also assuming that agents do not know the full structure of the network, but do know its link distribution. An AR(1) process for the underlying state induces an ARMA(1,1) process for the hierarchy of expectations, with current and lagged weighted averages of agents' idiosyncratic shocks entering at an aggregate level. For sufficiently irregular networks, these shocks do not wash out, thus causing persistent aggregate effects. I next apply this to firms' price-setting problem, demonstrating that even when firms possess complete price exibility, network learning induces considerable persistence in aggregate variables following monetary and real shocks and that network shocks plausibly represent a source of aggregate economic volatility. Finally...