Firm Risk and Leverage Based Business Cycles

I characterize cyclical fluctuations in the cross-sectional dispersion of firm-level productivity in the U.S. manufacturing sector. Using the estimated dispersion, or "risk," stochastic process as an input to a baseline DSGE financial accelerator model, I assess how well the model reproduces aggregate cyclical movements in the financial conditions of U.S. non-financial firms. In the model, risk shocks calibrated to micro data induce large and empirically-relevant fluctuations in leverage, a nancial measure typically thought to be closely associated with real activity. In terms of aggregate quantities, however, pure risk shocks account for only a small share of GDP fluctuations in the model, less than one percent. Instead, it is standard aggregate productivity shocks that explain virtually all of the model's real fluctuations. These results reveal a dichotomy at the core of a popular class of DSGE financial frictions models: risk shocks induce large financial fiuctuations, but have little effect on aggregate quantity fluctuations.