A Risk-Centric Model of Demand Recessions and Macroprudential Policy

67 Pages Posted: 25 Jul 2017 Last revised: 14 Jun 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 3 versions of this paper

Date Written: June 14, 2018

Abstract

When investors are unwilling to hold the economy’s risk, a decline in the interest rate increases the Sharpe ratio of the market and equilibrates the risk markets. If the interest rate is constrained from below, risk markets are instead equilibrated via a decline in asset prices. However, the latter drags down aggregate demand, which further drags prices down, and so on. If investors are pessimistic about the recovery, the economy becomes highly susceptible to downward spirals due to dynamic feedbacks between asset prices, aggregate demand, and growth. In this context, belief disagreements generate highly destabilizing speculation that motivates macroprudential policy.

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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