Risk shocks and macroeconomics

There is some good work going on in macroeconomics since the financial crisis. The forefront of this research is to try and incorporate finance variables into macro models. In a recent model in a paper called "Risk Shocks" by Christiano, Motto and Rostagno, the authors take the standard monetary dynamic general equilibrium model and add a financial accelerator mechanism. The goal is to see how financial shocks such as what were seen in 2008 will spill-over to the macro economy. The intuition is somewhat obvious but the link between financial and credit effects and GDP has often not been fully modeled directly. 

Capital is invested based on a expected return but this return is uncertain. You don't know the pay-off when an investment is made and this uncertainty makes investing risky. Entrepreneurs borrow money through a debt contract but these debt contracts change in price because the expected pay-off changes.
When risk is high there is premium for credit and it is harder to obtain. When risk is low, credit is cheap and easy to obtain.

The risk associated with credit can be shocked by a number of factors and this causes counter-cyclical credit spreads and pro-cyclical investment. The shocks to risk include value of the stock market, credit to non-financial firms, credit spreads, and the slope of the term structure.  Running simulations using this type of model, the authors find that fluctuations in financial risk can account for about 60% of the growth rate in aggregate US output. 

The implication are very important. Policy-makers should worry about what is happening in financial markets. Credit spreads and lending availability are important just like the overall rate of interest. Clearly, the focus by central banks on systemic risk is starting to address this issue, but the mandate of the Fed is for controlled inflation and full employment and is not looking to solve problems in the financial markets.

For a global macro investor, the research sends a clear signal that watching risk variables in the financial sector will have benefit for determining the direction of economic growth.