News, disaster risk, and time-varying uncertainty

Standard real business cycle models are often unable to replicate three empirical facts: positive output in response to good news, stochastic volatility of macro variables, and asymmetric business cycles. This paper proposes a unified basis for understanding these facts in a tractable dynamic stochastic general equilibrium (DSGE) model, in which the key is the interaction of information flows and disaster risk. Information flows fluctuate between two regimes with different precision levels for signals regarding future economic fundamentals. A shift in forecast precision changes the probability of entering an economic disaster. High disaster risk leads to low expected capital returns and a decline in hours, investment, and output. Changing information structures results in different volatility and skewness over the business cycle. Simple theory makes the two expectation effects through information flows and disaster risk transparent. Quantitatively, the model suggests that the interaction of the two expectation effects plays a significant role in accounting for the higher-order moments of the business cycle.