A Risk-Centric Model of Demand Recessions and Speculation

90 Pages Posted: 25 Jul 2017 Last revised: 23 Jul 2019

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); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 4 versions of this paper

Date Written: July 22, 2019

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 decline in risky asset valuations generates a demand recession. This reduces earnings and generates a negative feedback loop between asset prices and aggregate demand. In the recession phase, beliefs matter not only because they affect asset valuations but also because they determine the strength of the amplification mechanism. In the ex-ante boom phase, belief disagreements (or heterogeneous asset valuations) matter because they induce investors to speculate. This speculation exacerbates the crash by reducing high-valuation investors' wealth when the economy transitions to recession. Macroprudential policy that restricts speculation in the boom can Pareto improve welfare by increasing asset prices and aggregate demand in the recession.

Keywords: risk premium shocks, asset prices, aggregate demand, interest rate rigidity, booms and recessions, heterogeneous beliefs, speculation, monetary and macroprudential policy, the Fed put

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 Speculation (July 22, 2019). 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)

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Alp Simsek

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

Centre for Economic Policy Research (CEPR) ( email )

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