In this paper I study a two-sector general equilibrium model with habit preferences and capital adjustment costs. The effective risk-aversion is endogenous and increases after negative productivity shocks. The ensuing capital reallocation from the high-risk and high-productivity sector to the low-risk and low-productivity sector amplifies the reduction in aggregate productivity and aggregate consumption. The decrease in consumption places additional upward pressure on the effective risk aversion, which further depresses productivity and consumption. The model thus proposes a simple propagation mechanism that can account for observed patterns of slow recoveries after large shocks, and matches key business cycles and asset pricing moments, such as the mean and volatility of the risk-free rate, the equity premium, and Tobin’s q.
|Original language||English (US)|
|State||Unpublished - 2019|