A DSGE model of downside risk

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Authors: Luciano I. de Castro, Antonio F. Galvao, David Ke Hong
Cited by: 0
References: 43

Abstract

This paper presents a new dynamic stochastic general equilibrium (DSGE)framework based on recursive quantile preferences (quantile certainty equivalent),in which household downside risk attitudes are a model primitive. In this economy,infinitely lived households maximize the discounted value of the stream offuture τ-quantile utilities for τ ∈ (0, 1) with standard consumption and disutility oflabor. The quantile parameter τ captures the households’ downside risk attitude,independent of the elasticity of intertemporal substitution. Representative firmsare price takers, and prices are determined endogenously. We establish centralproperties of the model, including: (i) existence and uniqueness of a fixed pointfor household value functions, (ii) envelope condition, and the quantile Euler equation.We define the quantile recursive competitive equilibrium and establish itsexistence and uniqueness. We also provide an algorithm and numerically computethe quantile DSGE procedure. Lastly, we employ nonlinear impulse responsefunctions and present empirical results for the varying one-time technology shockimpulse response functions for augmented MaCurdy and KPR utility functions.We find significant heterogeneity in downside risk attitudes with the potentialfor countercyclical labor responses for a shallow shock in an otherwise frictionlessenvironment. Rates of dissipation of the shock also vary with the configuration.

Fields of Study & Subjects

Risk Management in Financial Firms

Publication details

Journal / source
Review of Economic Dynamics
Volume
61
Pages
101352–101352
Publication date
26 July 2026
Language
EN