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To construct a business cycle model consistent with the observed behavior of asset prices, and study the effect of shocks to aggregate uncertainty, the author introduces a small, time-varying risk of economic disaster in a standard real business cycle model. An increase in the perceived probability of disaster leads to a collapse of investment and a recession, an increase in risk spreads, and a decrease in the yield on safe assets. To assess the empirical validity of the model, the author infers the probability of disaster from observed asset prices and feed it into the model.
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