Business Cycles and Regime-Shift Risk

Abstract

The consumption growth data strongly favor a two-regime specification. The high volatility, low growth regime is associated with deep recessions: the Great Depression, the recession of 1937-1938, the post-war recession of 1945, and the most recent financial crisis. I develop parsimonious models in which (i) consumption and dividend growth follow regime-switching dynamics, (ii) the regime characteristics are consistent with the empirical evidence from the consumption growth data, and (iii) the risks associated with regime shifts are priced in asset markets. The models explain major regime-dependent asset market phenomena. Regime-shift risk exhibits the dominant influence on asset prices: It generates a high equity premium, and also induces time-varying risk premiums and explains the return predictability.