Rare disasters

In economics, a rare disaster is a collapse that is infrequent and large in magnitude, having a negative effect on an economy. Rare disasters are important because they provide an explanation of the equity premium puzzle, the behavior of interest rates, and other economic phenomena. In economics, a rare disaster is a collapse that is infrequent and large in magnitude, having a negative effect on an economy. Rare disasters are important because they provide an explanation of the equity premium puzzle, the behavior of interest rates, and other economic phenomena. The parameters for a rare disaster are a substantial drop in GDP and at least a 10% decrease in consumption. Examples include financial disasters: the Great Depression and the 1997 Asian financial crisis; wars: World War I, World War II, and regional conflicts; epidemics: influenza outbreaks and the Asian Flu; weather events; and earthquakes and tsunamis; however, any event that has a substantial impact on GDP and consumption could be considered a rare disaster. The idea was first proposed by Rietz in 1988, as a way to explain the equity premium puzzle. Since then, other economists have added to and strengthened the idea with evidence, but many economists are still skeptical of the theory. The model set forth by Barro is based upon the Lucas's fruit tree model of asset pricing with exogenous, stochastic production. The economy is closed, the number of trees is fixed, output equals consumption ( A t + 1 = C t ) and there is no investment or depreciation. As ( A t + 1 ) is the output of all the trees in the economy and ( P t {displaystyle {P_{t}}} ) is the price of the periods fruit (the equity claim). The equation below shows the gross return on the fruit tree in one period.