Faculty of Economics and Business Administration Publications Database

Safety traps

Benhima, Kenza
Volume: 5
Number: 4
Pages: 68 - 106
Month: October
ISSN-Print: 1945-7707
Link External Source: Online Version
Year: 2013

Fear of risk provides a rationale for protracted economic downturns. We develop a real business cycle model where investors with decreasing relative risk aversion choose between a risky and a safe technology that exhibit decreasing returns. Because of a feedback effect from the interest rate to risk aversion, two equilibria can emerge: a standard equilibrium and a "safe" one in which investors invest in safer assets. We refer to the dynamics of this second equilibrium as a safety trap because it is self-reinforcing as investors accumulate more wealth and show it to be consistent with Japan's lost decade.