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Keynes Fund

 

Summary of Project Plan


Large shocks such as the COVID-19 pandemic underscore the importance of understanding how economic agents perceive risk associated with ‘rare disasters’, defined as low-probability, high-impact events with sharp implications for asset prices and economic activity. Agents’ perceptions of disaster risk have been identified as a key factor hindering economic recovery following crises (Baker et al., 2020), while long-term scarring of beliefs has been argued to weigh on growth prospects and long-term economic outcomes (Kozlowski, Veldkamp, and Venkateswaran, 2020).

This analysis builds on a prominent literature which studies the financial and economic implications of a time-varying probability of disasters, where agents may revise their beliefs depending on circumstances (Gabaix (2012), Gourio (2012). In this project, we emphasize that beliefs about disasters are multi-dimensional and that the horizon over which agents perceive disaster risk (i.e., over the near or distant future) is crucial for understanding its effect on the economy. By way of example, the recent rise in COVID-19 infections may lead agents to revise their beliefs about the probability of a second wave and a repeat lock-down in the short-run, but may also lead them to revise their beliefs about the incidence and costs of pandemics in the long-run. These are two dimensions of risk that can affect saving and risk taking behaviour quite differently. Similar considerations apply to climate change: near-future concerns of extreme weather phenomena vis-a-vis concerns over the trend rise in temperatures leading to a higher frequency of extreme events in the coming decades.

In this project we propose a methodology combining empirics and theory to address three
main questions:

  • What do asset prices — in particular, the yield curve and equity prices — tell us about the evolution of disaster risk and its distribution over the short- and long-run?

  • What are the macroeconomic implications of changes in the distribution of disaster risk and what can we say about its transmission across countries?

  • What is the scope for macroeconomic and financial stabilization policies in open economies in the face of disasters, both ex ante and ex post?

We believe the project is fully aligned with the remit of the Keynes Fund. We combine theory in finance and macroeconomics, along with empirical work on asset prices to identify agents outlook for short and long-term risks and study the implications for economic fluctuations and policy. The project brings together authors from Cambridge and the Bank of England promoting the interaction between the two institutions and enhancing the opportunities for impact. Finally, the scope and complexity of the analysis will require the involvement and training of a Cambridge post-doctoral researcher and Ph.D. students, fostering intellectual cooperation.


*The views expressed here are those of the authors, and do not necessarily reflect the views of the Bank of England.

 

 

Professor Giancarlo Corsetti, Dr Simon Lloyd and Emile Marin

 

Professor Giancarlo Corsetti is Professor of Macroeconomics at the Faculty of Economics, University of Cambridge. He specialises in International Macroeconomics and Finance.

 

Dr. Simon Lloyd is a Senior Research Economist in the International Directorate of the Bank of England. His research focuses on International Macroeconomics and Finance.

 

Emile Marin ia a Ph.D. candidate at the Faculty of Economics, University of Cambridge. His research focuses on International Economics, Monetary Economics and Optimal Policy.

 

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