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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.

 

Project Output


Sharing Asymmetric Tail Risk Smoothing, Asset Pricing and Terms of Trade, Giancarlo Corsetti, Anna Lipińska and Giovanni Lombardo, Cambridge-INET Working Paper 2123

Abstract: With the Global Financial Crisis, the COVID-19 pandemic, and the looming Climate Change, investors and policymakers around the world are bracing for a new global environment with heightened tail risk. Asymmetric exposure to this risk across countries raises the private and social value of arrangements improving insurance. We offer an analytical decomposition of the welfare effects of efficient capital market integration into a "smoothing" and a "level effect". Enhancing risk sharing affects the volatility of consumption, but also brings about equilibrium adjustment in asset and goods prices. This in turn drives relative wealth and consumption, as well as labor and capital allocation, across borders. Using model simulation, we explore quantitatively the empirical relevance of the different channels through which riskier and safer countries benefit from sharing macroeconomic risk. We offer an algorithm for the correct solution of the equilibrium using DSGE models under complete markets, at higher order of approximation.

https://www.inet.econ.cam.ac.uk/research-papers/wp-abstracts?wp=2123

 

Foreign Vulnerabilities, Domestic Risks: The Global Drivers of GDP-at-Risk, Simon Lloyd, Ed Manuel and Konstantin Panchev, Janeway Institute Working Paper 2102

Abstract: We study how foreign financial developments influence the conditional distribution of domestic GDP growth. Within a quantile regression setup, we propose a method to parsimoniously account for foreign vulnerabilities using bilateral-exposure weights when assessing downside macroeconomic risks. Using a panel dataset of advanced economies, we show that tighter foreign financial conditions and faster foreign credit-to-GDP growth are associated with a more severe left tail of domestic GDP growth, even when controlling for domestic indicators. The inclusion of foreign indicators significantly improves estimates of ‘GDP-at-Risk’, a summary measure of downside risks. In turn, this yields time-varying estimates of higher GDP growth moments that are interpretable and provide advanced warnings of crisis episodes. Decomposing historical estimates of GDP-at-Risk into domestic and foreign sources, we show that foreign shocks are a key driver of domestic macroeconomic tail risks.

https://www.inet.econ.cam.ac.uk/research-papers/jiwp-abstracts?wp=2102

 


*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.

 

Daniel Ostry ia a Ph.D. candidate at the Faculty of Economics, University of Cambridge. His research focuses on Macro-Finance and Disaster Risk.

 

Cambridge Working Papers in Economics (CWPE)


 
 

 

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