Epstein-Zinn-Weil preferences to the rescue (again)
Xavier Gabaix and Robert Barro are, in my opinion, on to something really intriguing and good with their work on the effects of rare disasters.
Now, in a new NBER working paper (ungated copy here) titled "Crises and Recoveries in an Empirical Model of Consumption Disasters", Emi Nakamura, Jon Steinsson, Robert Barro and Jose Ursua introduce a new twist, viz. Epstein-Zinn-Weil preferences.
Well because of this:
In a model with power utility and standard values for risk aversion, stocks surge at the onset of a disaster due to agents' strong desire to save. This counterfactual prediction causes a low equity premium, especially in normal times. In contrast, a model with Epstein-Zin-Weil preferences and an intertemporal elasticity of substitution equal to 2 yields a sizeable equity premium in normal times for modest values of risk aversion.
People, those are some magic preferences!