A Risk-Centric Model of Demand Recessions and Macroprudential Policy

89 Pages Posted: 25 Jul 2017 Last revised: 19 Sep 2018

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Alp Simsek

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: June 14, 2018

Abstract

We theoretically analyze the interactions between asset prices, financial speculation, and macroeconomic outcomes when output is determined by aggregate demand. If the interest rate is constrained, a rise in the risk premium lowers asset prices and generates a demand recession. This reduces earnings and generates a feedback loop between asset prices and aggregate demand. The recession is exacerbated by speculation due to heterogeneous asset valuations during the ex-ante low-risk-premium period. Macroprudential policy that restricts speculation can Pareto improve welfare. We also provide empirical support for the mechanisms by comparing impulse responses to house price shocks within and outside the Eurozone.

Keywords: Risk gap, output gap, time-varying risk premium, risk-premium shocks, asset prices, aggregate demand, aggregate supply, liquidity trap, interest rates, rstar, portfolio choice, Sharpe ratio, monetary and macroprudential policy, heterogeneous beliefs, speculation, tail risk, endogenous volatility

JEL Classification: E00, E12, E21, E22, E30, E40, G00, G01, G11

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, A Risk-Centric Model of Demand Recessions and Macroprudential Policy (June 14, 2018). MIT Department of Economics Working Paper No. 17-07. Available at SSRN: https://ssrn.com/abstract=3004727 or http://dx.doi.org/10.2139/ssrn.3004727

Ricardo J. Caballero (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Alp Simsek

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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HOME PAGE: http://https://economics.mit.edu/faculty/asimsek

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
United States

HOME PAGE: http://https://economics.mit.edu/faculty/asimsek

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