The Tail that Keeps the Riskless Rate Low

Julian Kozlowski, Laura Veldkamp and Venky Venkateswaran
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Laura Veldkamp: New York University

No 1111, 2018 Meeting Papers from Society for Economic Dynamics

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.

Date: 2018
New Economics Papers: this item is included in nep-dge
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Citations: View citations in EconPapers (11)

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Related works:
Chapter: The Tail That Keeps the Riskless Rate Low (2018)
Working Paper: The Tail that Keeps the Riskless Rate Low (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed018:1111

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