International Finance Discussion Papers (IFDP)
The impact of risk cycles on business cycles: a historical view
Jon Danielsson, Marcela Valenzuela, and Ilknur Zer
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
PDF: Full Paper
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