A Risk-centric Model of Demand Recessions and Speculation

Alp ÅžimÅŸek and Ricardo Caballero ()

No 13815, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 (search for similar items in EconPapers)
JEL-codes: E00 E12 E21 E22 E30 E40 G00 G01 G11 (search for similar items in EconPapers)
Date: 2019-06
New Economics Papers: this item is included in nep-cba, nep-mac and nep-ore
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Citations: View citations in EconPapers (5)

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Related works:
Journal Article: A Risk-Centric Model of Demand Recessions and Speculation* (2020)
Working Paper: A Risk-centric Model of Demand Recessions and Speculation (2017)
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