Real business cycle (RBC) models describe how firms make investment and labour decisions. They assume that technological shocks and changes in productivity are the primary drivers of macroeconomic fluctuations. However, these models generally fall short of explaining how choices made within firms—which might modify external shocks—might affect macroeconomic dynamics and asset prices. In addition, one key determinants of asset price, risk aversion, exhibits negligible impacts on economic outcomes in these models. To address these oversights, HKUST’s Zhanhui Chen and colleagues present an updated model that acknowledges the key roles of within-firm variables—namely firms’ technology choice and risk aversion in the economy—in the real business environment.

“In the standard RBC model,” say the researchers, “production plans are made one period ahead and technology is exogenously given.” Although this approach to planning and prediction accounts for shocks that originate outside firms, it does not fully consider how firms’ internal characteristics, such as their choices of technology (affected by risk aversion preferences), could drive investment and output. As a result, risk aversion is often assumed to have only small and indirect effects on the macroeconomy. “Yet, cyclical variations in risk aversion play a prominent role in explaining the variations in expected excess returns of the stock market,” say the authors.

To address the shortcomings of the conventional RBC approach to predicting stock market returns, the researchers proposed and empirically tested a refined theoretical model that accounted for the time-varying evolution of risk aversion. “If technology choice and variations in risk aversion drive asset prices and macro-economic quantities, as in our model, then we should find empirical evidence for such a relation,” hypothesized the researchers.

Their results were in line with this hypothesis. Not only did their model “reproduce standard macroeconomic and asset pricing moments at least as well as a benchmark model,” but it also displayed unique features. “Technology choice and risk aversion move counter to an exogenous shock,” the researchers report. “Thereby, they delay the reaction of investment and consumption to the shock.” The researchers’ empirical tests supported their argument that “asset prices and the macroeconomy are linked through variations in risk aversion.” However, “risk aversion does not directly affect the macroeconomy, but only through technology choice,” add the authors.

Improving on the assumptions of the conventional RBC model, the researchers shed new light on the linkage between firms’ technology choices and risk aversion and its macro-economic consequences. Their new model offers firms a more realistic and accurate tool for production planning and investment decision. This pioneering study lays the groundwork for future research that could have far-reaching implications, as firms and economies alike will benefit from understanding the impact of within-firm variables and risk aversion on asset prices and the macro-economy.