Flight to safety in macroeconomics: role of cyclical risk aversion

Yadav, Jayant (2021) Flight to safety in macroeconomics: role of cyclical risk aversion. PhD thesis, University of Glasgow.

Abstract

The thesis contains three main chapters that investigate the Flight to Safety phenomenon and its impact on the macroeconomy from an empirical and theoretical perspective. In doing so, it advocates for a more significant role of investors’ time-varying, state-varying and cyclical risk aversion in macroeconomic models and policy analysis. The first chapter establishes that Flight to Safety, a sudden and short term asset market phenomenon is worth the attention, as the identified Flight to Safety shocks have long-run adverse impact on US business cycles. The investigation then takes the direction to theoretically formalize the role of Flight to Safety in micro-founded DSGE models. The second chapter establishes that similar to the asymmetric impact of flight of capital (to safety or risk) on asset markets, the optimal policy for investors with cyclical risk-aversion should also be asymmetric in costly recessions. The third chapter brings the analysis back to Flight to Safety by demonstrating it as an optimal response in costly recessions when risk-averse investors have a low risk-bearing capacity.

The thesis makes multiple contributions of which the three major ones are as follows. Firstly, its central conviction is to identify the role of Flight to Safety as the critical driver of business cycle fluctuations. By means of structural VAR model, it shows that Flight to Safety shocks predate any regress in total factor productivity by several years, and account for more than 50% of fluctuations in macroeconomic variables at business cycle frequency. The finding that FTS can generate a long and sustained decline in investment-related macroeconomic variables asks several questions from the established tenets of business cycle dynamics. It proposes an alternative view that shocks to investors’ risk aversion lead to booms and busts in business cycles. Secondly, the thesis shows that precautionary savings behaviour matters, and it changes non-linearly in the amount of information and control agents have over their future consumption. Therefore, optimal discretionary policy needs to actively and asymmetrically manage this precautionary behaviour. A policymaker without an ability to observe the output gap can also replicate the optimal strategy by restoring the equity premium to its steady-state level. Lastly, the thesis demonstrates that households near the upper or lower ends of their risk-bearing capacity demonstrate sudden changes in their risk allocation that echo with the ‘risk on’ and ‘risk off’ phenomena. It also challenges the standing approach in literature to consider Flight to Safety phenomenon only as an aberrant reaction to some form of market externalities, constraints or uncertainty and thereby overlooking it for monetary policy.

• Item Type: Thesis (PhD)
• Qualification Level: Doctoral
• Keywords: Flight to Safety, Optimal policy, Asymmetry, Non-linear optimisation, Structural VAR, Time-varying risk aversion, Business cycles, Sign restricitons.
• Subjects: H Social Sciences > HB Economic Theory
• Colleges/Schools: College of Social Sciences > Adam Smith Business School > Economics
• Funder's Name: Economic and Social Research Council (ESRC)
• Supervisor's Name: Leith, Prof. Campbell and Nolan, Prof. Charles
• Date of Award: 2021
• Depositing User: Dr Jayant Yadav
• Unique ID: glathesis:2021-81958
• Copyright: Copyright of this thesis is held by the author.
• Date Deposited: 01 Feb 2021 07:54
• Last Modified: 01 Feb 2021 08:02
• Thesis DOI: 10.5525/gla.thesis.81958
• URI: https://theses.gla.ac.uk/id/eprint/81958

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