Asset Prices and Aggregate Demand in a "Covid-19" Shock: A model of Endogenous Risk Intolerance and LSAPs

36 Pages Posted: 16 Apr 2020 Last revised: 10 Aug 2020

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)

Date Written: August 7, 2020

Abstract

In this paper we: (i) provide a model of endogenous risk intolerance and serve aggregate demand contractions following a large (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 prices 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. Optimal LSAPs are larger when the (consolidated) government has greater future fiscal capacity and the downward spiral is more severe. In an extension, we show how corporate debt overhang problems strengthen our mechanisms. The Covid-19 shock and the large response by all the major central banks provide a vivid illustration of the environment we seek to capture.

Keywords: Volatility, leverage, asset price spirals, aggregate supply and demand, recessions, conventional and unconventional monetary policy, multiple equilibria, LSAPs, public guarantees, the Fed put, COVID-19

JEL Classification: E00, E12, E21, E22, E30, E40, G00, G01, G11

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, Asset Prices and Aggregate Demand in a "Covid-19" Shock: A model of Endogenous Risk Intolerance and LSAPs (August 7, 2020). Available at SSRN: https://ssrn.com/abstract=3576979 or http://dx.doi.org/10.2139/ssrn.3576979

Ricardo J. Caballero (Contact Author)

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Alp Simsek

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