Title: Risk as fuel of the business cycle
Authors: Christoph Schult - Halle Institute for Economic Research (Germany) [presenting]
Abstract: The aim is to develop a dynamic stochastic general equilibrium (DSGE) model with risky capital and oil as production factors. The production function of the representative firm is a nested constant elasticity of substitution function. The model is estimated using Bayesian techniques with economic data and on oil prices, production and consumption for the United States. The interaction between risk, investment decisions of firms, and the oil market are analysed, taking the short-run elasticity of substitution between oil and capital and the propagation mechanisms between risk in capital production and oil price movements into account. The model is used to reassess the contribution of the different potential drivers to the business cycle controlling for fluctuations in oil markets. Significant findings are that the contributions of financial market frictions and oil market disturbances to the US business cycle are low and that financial market disturbances mainly drove the Great Recession. The model can quantify the impact of climate change mitigation policies on the economy. Climate change mitigation policies, e.g. increasing oil taxes, to reduce crude oil consumption by 10\% can cause a contraction of GDP by 1 to 2\% and increases inflation. Monetary policy can stabilize inflation increasing the federal funds rate dependent on the degree of financial market imperfections by 0.15 to 0.40 percentage points annually.