Working Paper: CEPR ID: DP16793
Authors: Sushant Acharya; Keshav Dogra; Sanjay R. Singh
Abstract: We formalize the idea that the financial sector can be a source of non-fundamental risk. Households' desire to hedge against price volatility can generate price volatility in equilibrium, even absent fundamental risk. Fearing that asset prices may fall, risk-averse households demand safe assets from leveraged intermediaries, whose issuance of safe assets exposes the economy to self-fulfilling fire sales. Policy can eliminate non-fundamental risk by (i) increasing the supply of publicly backed safe assets, through issuing government debt or bailing out intermediaries, or (ii) reducing the demand for safe assets, through social insurance or by acting as a market maker of last resort.
Keywords: Safe Assets; Self-fulfilling; Asset Market Crashes; Liquidity; Fire Sales
JEL Codes: D52; D84; E62; G10; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial sector (G21) | nonfundamental risk (G19) |
| households' demand for safe assets (D14) | price volatility (G13) |
| risk-averse households demand safe assets (D11) | fire sales (G33) |
| fire sales (G33) | price declines (E30) |
| policy interventions (D78) | financial stability (G28) |
| households' anticipation of price declines (D12) | insurance demand (G52) |
| insurance demand (G52) | fire sales (G33) |