Firm Risk and Leverage-Based Business Cycles

I characterize cyclical fluctuations in the cross-sectional dispersion of firm-level productivity. Using the micro-estimated dispersion, or “risk,” stochastic process as an input to a baseline DSGE financial accelerator model, I assess how well the model reproduces cyclical movements in both real and financial conditions of the economy. In the model, risk shocks calibrated to micro data lead to empirically-relevant steady-state leverage, a financial measure typically thought to be closely associated with real activity. In terms of aggregate quantities, however, pure risk shocks account for only a small share of GDP fluctuations in the model, less than one percent. Instead, standard aggregate productivity shocks explain virtually all of the model’s real fluctuations. These results do not necessarily reveal a dichotomy at the core of a popular class of DSGE financial frictions models. Rather, it is the magnitude of micro-estimated vs. macro-estimated risk shocks that are critical for aggregate quantity fluctuations.