A risk-centric model of demand recessions and macroprudential policy

Ricardo Caballero () and Alp Simsek

No 733, BIS Working Papers from Bank for International Settlements

Abstract: When investors are unwilling to hold the economy's risk, a decline in the interest rate increases the Sharpe ratio of the market and equilibrates the risk markets. If the interest rate is constrained from below, risk markets are instead equilibrated via a decline in asset prices. However, the latter drags down aggregate demand, which further drags prices down, and so on. If investors are pessimistic about the recovery, the economy becomes highly susceptible to downward spirals due to dynamic feedbacks between asset prices, aggregate demand, and potential growth. In this context, belief disagreements generate highly destabilizing speculation that motivates macroprudential policy.

Keywords: risk gap; output gap; risk-premium shocks; aggregate demand; liquidity trap; "rstar"; Sharpe ratio; monetary and macroprudential policy; heterogeneous beliefs; speculation; endogenous volatility (search for similar items in EconPapers)
JEL-codes: E00 E12 E21 E22 E30 E40 G00 G01 G11 (search for similar items in EconPapers)
Pages: 68 pages
Date: 2018-07
New Economics Papers: this item is included in nep-cba and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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