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A DSGE Model of Downside Risk
Journal article   Open access   Peer reviewed

A DSGE Model of Downside Risk

Luciano I. de Castro, Antonio F. Galvao and David Hong
Review of economic dynamics, Vol.61, 101352
08/2026
DOI: 10.1016/j.red.2026.101352
url
https://doi.org/10.1016/j.red.2026.101352View
Published (Version of record) Open Access

Abstract

This paper develops a DSGE model with recursive quantile preferences and rare disaster risk. In this economy, infinitely lived households maximize the discounted value of the stream of future τ-quantile utilities for τ ∈ (0, 1). The quantile parameter τ captures the households’ downside risk attitude, independent of the elasticity of intertemporal substitution. We establish central properties of the model, including: (i) existence and uniqueness of a fixed point for household value functions, (ii) envelope condition, and the quantile Euler equation. We define the quantile recursive competitive equilibrium and establish its existence and uniqueness. Quantitatively, following a one-standard-deviation positive technology shock, output, consumption, and investment increase on impact and gradually return to baseline. In contrast, labor adjusts differently under recursive quantile preferences: initial labor hours decline, indicating that a preference-based tilt toward downside outcomes alters intratemporal tradeoffs even in an otherwise frictionless setting. Similar qualitative responses arise following rare-disaster shocks
 business cycle downside risk general equilibrium quantile impulse response function recursive quantile preferences

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