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We augment a standard monetary dynamic general equilibrium model to include a Bernanke-Gertler-Gilchrist financial accelerator mechanism. We fit the model to US data, allowing the volatility of cross-sectional idiosyncratic uncertainty to fluctuate over time. We refer to this measure of volatility as risk. We find that fluctuations in risk are the most important shock driving the business cycle. (JEL D81, D82, E32, E44, L26)We introduce agency problems associated with financial intermediation into an otherwise standard model of business cycles. Our estimates suggest that fluctuations in the severity of these agency problems account for a substantial portion of business cycle fluctuations over the past two and a half decades.The agency problems we introduce are those associated with asymmetric information and costly monitoring proposed by Townsend (1979). Our implementation most closely follows the work of Bernanke and Gertler (1989) and Bernanke, Gertler, and Gilchrist (1999)-henceforth, BGG. 1 Entrepreneurs play a central role in the model. They combine their own resources with loans to acquire raw capital. They then convert raw capital into effective capital in a process that is characterized by idiosyncratic uncertainty. We refer to the magnitude of this uncertainty as risk. The notion that idiosyncratic uncertainty in the allocation of capital is important in practice can be motivated informally in several ways. For example, it is well known that a large 1 Other important early contributions to the role of costly state verification in business cycles include the work of Williamson (1987); Carlstrom and Fuerst (1997);and Fisher (1999). More recent contributions include the work of Christiano, Motto, and Rostagno (

4Non-technical summary 5

Historical data and model simulations support the following conclusion. Inflation is low during stock market booms, so that an interest rate rule that is too narrowly focused on inflation destabilizes asset markets and the broader economy. Adjustments to the interest rate rule can remove this source of welfarereducing constructing the inflation forecast) would reduce the volatility of output and asset prices.