Disasterization: A Simple Way to Fix the Asset Pricing Properties of Macroeconomic Models

A central difficulty in economics is to create a model economy that has both good business cycle properties and good asset pricing properties. Macro models have the former, fail in the latter. Finance models typically work with endowment economies, and are hard to integrate with macro. I show how to solve this difficulty by a simple, portable, modelling device, the “disasterization” procedure. Take an economy with good business cycle properties, and create a new, “disasterized” economy, which is essentially identical to the original one, except that, disasters can destroy part of the capital stock and productivity. In the disasterized economy, asset prices exhibit high and volatile risk premia, but investment, employment, the short-term real interest rate remain the same as in the original economy. Hence, we have a tractable unified framework to think about both the macroeconomy and the financial side. As an application, I consider a long-standing difficulty in macro-finance, Tobin’s . In the model, like in the real world, stock market valuations () are very volatile, negatively correlated with future stock returns, but uncorrelated with investment. I conclude by showing ∗[email protected]. For helpful conversations and comments, I thank seminar participants at Duke, the IMF, Federal Reserve Board, MIT, NYU, the 2007 Texas Finance Festival. I thank the NSF for support. This paper started circulating in January 2007, as part of Gabaix (2007), which splitted into Gabaix (2010) and the present paper.