A Risk-Centric Model of Demand Recessions and Macroprudential Policy

89 Pages Posted: 25 Jul 2017 Last revised: 23 Sep 2018

See all articles by Ricardo J. Caballero

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: October 21, 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 premium shocks, asset prices, aggregate demand, interest rate rigidity, booms and recessions, heterogeneous beliefs, speculation, monetary and macroprudential policy

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 (October 21, 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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National Bureau of Economic Research (NBER) ( email )

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

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