Joint with Yicheng ZhuNovember 2019
Time-varying likelihood of large adverse macroeconomic shocks (i.e. disaster risk shocks) can reconcile many asset pricing patterns and macroeconomic dynamics. Yet it requires excessively huge "disaster” size, and it generates unrealistic downward-sloping term structure of real interest rates. With labor market frictions, moderate adverse economic shocks can endogenously trigger “disastrous” rapid economic downturns followed by slow recoveries. Such overshooting and slow recovery transitional dynamics have crucial asset pricing implications: they reconcile excessive fluctuations in labor market flows and stock returns with smooth consumption process; and more importantly, they generate upward-sloping term structure of real interest rates, even when business cycles are largely driven by disaster risk shocks.