Ambiguity in a Pandemic Recession, Asset Prices, and Lockdown Policy

Abstract

Using an asset pricing model of a multisector production economy including pandemic disaster, we explain the average stock price boom and significant cross-sectional variation of stock returns in the US and Japan during the COVID-19 pandemic recession. We find that two features of the pandemic, namely ambiguity and sector-specific shocks, are critical determinants of the unusual asset price dynamics observed. Extending the model, we analyze the welfare effects of lockdown policy during pandemics for heterogeneous households. We theoretically show that enforcing a lockdown improves the welfare of asset holders and households working in sectors with positive sector-specific shocks. Consequently, a Pareto-optimal lock- down policy controls for the tightness of lockdown to maximize the welfare of households working in sectors with negative sector-specific shocks.

Keywords: Ambiguity, Asset prices, COVID-19, Heterogeneous agents, Welfare

JEL Classification: D81, D53, E44, G12, H12