Idiosyncratic Production Risk, Growth and the Business Cycle

Abstract

We introduce a neoclassical growth economy with idiosyncratic production risk and incomplete markets. The general equilibrium is characterized in closed form. Uninsurable production shocks introduce a risk premium on private equity and typically result in a lower steady-state level of capital than under complete markets. In the presence of such risks, the anticipation of low investment and high interest rates in the future discourages risk-taking and feeds back into low investment in the present. An endogenous macroeconomic complementarity thus arises, which slows down convergence and amplifies the magnitude and persistence of the business cycle. These results — contrasting sharply with those of Aiyagari (1994) and Krusell and Smith (1998) — highlight that idiosyncratic production or capital-income risk can have significant adverse effects on capital accumulation and aggregate volatility. Keywords: Capital income, Entrepreneurial risk, Fluctuations, Growth, Investment, Precautionary savings.