A Model of Endogenous Risk Intolerance and LSAPs: Asset Prices and Aggregate Demand in a 'COVID-19' Shock
61 Pages Posted: 16 Apr 2020 Last revised: 17 Jun 2022
Date Written: March 21, 2021
In this paper we: (i) provide a model of the endogenous risk intolerance and severe asset price and aggregate demand contractions following an adverse real (non-financial) shock; and (ii) demonstrate the effectiveness of Large Scale Asset Purchases (LSAPs) in addressing these contractions. The key mechanism stems from heterogeneous risk tolerance: as a recessionary shock hits the economy and brings down asset prices, risk-tolerant agents' wealth share declines and their leverage rises endogenously. This reduces the market's risk tolerance and generates downward pressure on asset prices and aggregate demand. When monetary policy is unconstrained, it can offset the decline in risk tolerance with an interest rate cut that boosts the market's Sharpe ratio. However, if the interest rate policy is constrained, new contractionary feedbacks arise: recessionary shocks lead to further asset price and output drops, which feed the risk-off episode and trigger a downward loop. In this context, LSAPs improve asset prices and aggregate demand by transferring risk to the government's balance sheet, which reduces the market's required Sharpe ratio and reverses the contractionary feedbacks. Quantitatively, we show that aggregate shocks and LSAPs have large impacts on asset prices when the model is calibrated to fit the inelastic demand for aggregate assets uncovered in recent literature. We also show that heterogeneity in risk tolerance explains part of the demand inelasticity in normal times, and further reduces the elasticity after a recessionary shock. The COVID-19 shock and the large response by all major central banks provide a vivid illustration of the environment we seek to capture.
Keywords: Risk intolerance, leverage, asset price spirals, aggregate supply and demand, recessions, conventional and unconventional monetary policy, multiple equilibria, LSAPs, asset demand (in)elasticity, COVID-19
JEL Classification: E30, E40, E50, G01, G10, G20
Suggested Citation: Suggested Citation