A Risk-Centric Model of Demand Recessions and Macroprudential Policy
67 Pages Posted: 25 Jul 2017 Last revised: 14 Jun 2018
Date Written: June 14, 2018
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: Suggested Citation