Working Paper

The impact of risk cycles on business cycles: a historical view

Abstract: We investigate the effects of financial risk cycles on business cycles, using a panel spanning 73 countries since 1900. Agents use a Bayesian learning model to form their beliefs on risk. We construct a proxy of these beliefs and show that perceived low risk encourages risk-taking, augmenting growth at the cost of accumulating financial vulnerabilities, and therefore, a reversal in growth follows. The reversal is particularly pronounced when the low-risk environment persists and credit growth is excessive. Global-risk cycles have a stronger effect on growth than local-risk cycles via their impact on capital flows, investment, and debt-issuer quality.

Keywords: Stock market volatility; Uncertainty; Monetary policy independence; Financial instability; Risk-taking; Global financial cycles;

JEL Classification: F30; F44; G15; G18; N10; N20;

https://doi.org/10.17016/IFDP.2022.1358

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2022-09-09

Number: 1358