Entrepreneurial Activity, Risk and the Business Cycle∗

This paper analyzes a model in which the risk associated with entrepreneurial activity implies that the amount of such activity is procyclical and results in both amplification and intertemporal propagation of productivity shocks. In the model risk averse agents choose between a riskless project and a risky project with higher expected return (‘the entrepreneurial activity’). Agents who choose the entrepreneurial activity need to bear part of the project-specific risk for incentive reasons. Under the optimal contract more agents become entrepreneurs when productivity is high, because agents are more willing to bear risk and, in fact, need to bear less risk for incentive reasons. Thus, entrepreneurial activity amplifies productivity shocks and can be correlated across time even if productivity shocks are independent. In particular, propagation can be asymmetric and result in ‘sharp’ recessions. Furthermore, cross-sectional heterogeneity can be countercyclical, i.e., inequality may rise in recessions. ∗I thank Marco Bassetto, Denis Gromb, Lars Hansen, Arvind Krishnamurthy, Deborah Lucas, Alexander Monge, Mitchell Petersen, Lars Stole, Robert Townsend, seminar participants at the University of Chicago, the University of Pennsylvania (Wharton), the 1999 SED Annual Meetings, the 1999 Workshop in Economic Theory (Venice), the 1999 SITE Summer Workshop, the 2000 World Congress of the Econometric Society and especially Andrea Eisfeldt, Thomas Sargent and José Scheinkman for helpful comments. I gratefully acknowledge financial support from the University of Chicago through the Century Fellowship and the William Rainey Harper Dissertation Fellowship and from the Alfred P. Sloan Doctoral Dissertation Fellowship. Address: Adriano Rampini, Department of Finance, Kellogg Graduate School of Management, Northwestern University, 2001 Sheridan Rd., Evanston, IL 60208. Email: [email protected].