Risk Premium Shocks Can Create Inefficient Recessions

We develop a simple flexible-price model of business cycles driven by spikes in risk premiums. Aggregate shocks increase firms’ uninsurable idiosyncratic risk and raise risk premiums. We show that risk shocks can create quantitatively plausible recessions, with contractions in employment, consumption, and investment. Business cycles are inefficient — output, employment, and consumption fall too much during recessions, compared to the constrained-efficient allocation. Optimal policy involves stimulating employment and consumption during recessions.