A Risk-Centric Model of Demand Recessions and Speculation*
Name
w23614.pdf
Description
Accepted version
Size
1.53 MB
Format
Adobe PDF
Checksum (MD5)
13d4563941b00929b335d23c400ef49e
Author(s)
Caballero, Ricardo J
Simsek, Alp
Date Issued
2020
Journal
Quarterly Journal of Economics
Publisher
Oxford University Press (OUP)
Citation
Caballero, Ricardo J and Simsek, Alp. 2020. "A Risk-Centric Model of Demand Recessions and Speculation*." Quarterly Journal of Economics, 135 (3).
Version
Author's final manuscript
Abstract
© 2020 The Author(s) 2020. Published by Oxford University Press on behalf of President and Fellows of Harvard College. We provide a continuous-time "risk-centric"representation of the New Keynesian model, which we use to analyze the interactions between asset prices, financial speculation, and macroeconomic outcomes when output is determined by aggregate demand. In principle, interest rate policy is highly effective in dealing with shocks to asset valuations. However, in practice monetary policy faces a wide range of constraints. If these constraints are severe, 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, average beliefs matter because they not only affect asset valuations but also 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, which depresses (wealth-weighted) average beliefs. Macroprudential policy that restricts speculation in the boom can Pareto improve welfare by increasing asset prices and aggregate demand in the recession.
MIT Department
Massachusetts Institute of Technology. Department of Economics
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Creative Commons Attribution-Noncommercial-Share Alike
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DOI of Published Version
https://doi.org/10.1093/QJE/QJAA008
