Risk Premium Shocks Can Create Inefficient Recessions

We develop an equilibrium theory of business cycles driven by spikes in risk premiums that depress business demand for capital and labor. Aggregate shocks increase firms’ uninsurable idiosyncratic risk and raise risk premiums. We show that risk shocks can create quantitatively realistic recessions, with contractions in employment, consumption, and investment. Business cycles are inefficient — output and employment fall too much during recessions, compared to the constrained-efficient allocation, and consumption should rise. Optimal policy involves stimulating employment and consumption during recessions.