Working Paper: CEPR ID: DP13815
Authors: Ricardo Caballero; Alp Simsek
Abstract: 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 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, 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.
Keywords: asset prices; aggregate demand; time-varying risk premium; interest rate rigidity; booms and recessions; belief disagreements; speculation; monetary and macroprudential policy; uncertainty shocks; extrapolation
JEL Codes: E00; E12; E21; E22; E30; E40; G00; G01; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Decline in risky asset valuations (G19) | Demand recession (E65) |
| Demand recession (E65) | Earnings reduction (J31) |
| Earnings reduction (J31) | Negative feedback loop between asset prices and aggregate demand (E19) |
| Belief disagreements among investors (G40) | Speculation (D84) |
| Speculation (D84) | Economic downturns (E32) |
| Interest rate constraints (E43) | Amplified fluctuations in asset valuations and aggregate demand (E32) |
| Macroprudential policies (E61) | Stabilization of asset prices and support for aggregate demand during recessions (E63) |
| Shocks to asset valuations (G19) | More severe demand recessions in constrained interest rate environments (E47) |
| Past bank credit expansion (E51) | Worse outcomes following house price shocks (G59) |