Working Paper: NBER ID: w23614
Authors: Ricardo J. 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 macro- economic 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: risk-centric model; demand recessions; speculation; macroprudential policy
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) |
| asset prices (G19) | aggregate demand (E00) |
| rise in risk premium (G19) | decline in asset prices (G19) |
| decline in asset prices (G19) | expected earnings (G17) |
| expected earnings (G17) | demand recession (E65) |
| speculation (D84) | asset price fluctuations (G19) |
| asset price fluctuations (G19) | demand recession (E65) |
| macroprudential policies (E60) | asset prices (G19) |
| macroprudential policies (E60) | aggregate demand (E00) |