Working Paper: NBER ID: w24362
Authors: Julian Kozlowski; Laura Veldkamp; Venky Venkateswaran
Abstract: Riskless interest rates fell in the wake of the financial crisis and have remained low. We explore a simple explanation: This recession was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to re-assess macro risk, in particular, the probability of tail events. Since changes in beliefs endure long after the event itself has passed, perceived tail risk remains high, generates a demand for riskless, liquid assets, and continues to depress the riskless rate. We embed this mechanism in a simple production economy with liquidity constraints and use observable macro data, along with standard econometric tools, to discipline beliefs about the distribution of aggregate shocks. When agents observe an extreme, adverse realization, they re-estimate the distribution and attach a higher probability to such events recurring. As a result, even transitory shocks have persistent effects because, once observed, the shock stays forever in the agents' data set. We show that our belief revision mechanism can help explain the persistent nature of the fall in the risk-free rates.
Keywords: No keywords provided
JEL Codes: E43; E44; G01; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| observing extreme adverse realizations (D80) | persistent increase in perceived tail risk (G40) |
| persistent increase in perceived tail risk (G40) | decline in riskless interest rates (E43) |
| observing extreme adverse realizations (D80) | decline in riskless interest rates (E43) |
| belief changes about tail risks (D81) | observed interest rates (E43) |