A Risk-Centric Model of Demand Recessions and Speculation*
© 2020 The Author(s) 2020. Published by Oxford University Press on behalf of President and Fellows of Harvard College. 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,...
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Format: | Article |
Language: | English |
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Oxford University Press (OUP)
2022
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Online Access: | https://hdl.handle.net/1721.1/144451 |
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author | Caballero, Ricardo J Simsek, Alp |
author2 | Massachusetts Institute of Technology. Department of Economics |
author_facet | Massachusetts Institute of Technology. Department of Economics Caballero, Ricardo J Simsek, Alp |
author_sort | Caballero, Ricardo J |
collection | MIT |
description | © 2020 The Author(s) 2020. Published by Oxford University Press on behalf of President and Fellows of Harvard College. 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 because they not only affect asset valuations but also 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. |
first_indexed | 2024-09-23T08:05:00Z |
format | Article |
id | mit-1721.1/144451 |
institution | Massachusetts Institute of Technology |
language | English |
last_indexed | 2024-09-23T08:05:00Z |
publishDate | 2022 |
publisher | Oxford University Press (OUP) |
record_format | dspace |
spelling | mit-1721.1/1444512024-01-02T20:34:27Z A Risk-Centric Model of Demand Recessions and Speculation* Caballero, Ricardo J Simsek, Alp Massachusetts Institute of Technology. Department of Economics © 2020 The Author(s) 2020. Published by Oxford University Press on behalf of President and Fellows of Harvard College. 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 because they not only affect asset valuations but also 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. 2022-08-26T12:43:37Z 2022-08-26T12:43:37Z 2020 2022-08-26T12:00:49Z Article http://purl.org/eprint/type/JournalArticle https://hdl.handle.net/1721.1/144451 Caballero, Ricardo J and Simsek, Alp. 2020. "A Risk-Centric Model of Demand Recessions and Speculation*." Quarterly Journal of Economics, 135 (3). en 10.1093/QJE/QJAA008 Quarterly Journal of Economics Creative Commons Attribution-Noncommercial-Share Alike http://creativecommons.org/licenses/by-nc-sa/4.0/ application/pdf Oxford University Press (OUP) NBER |
spellingShingle | Caballero, Ricardo J Simsek, Alp A Risk-Centric Model of Demand Recessions and Speculation* |
title | A Risk-Centric Model of Demand Recessions and Speculation* |
title_full | A Risk-Centric Model of Demand Recessions and Speculation* |
title_fullStr | A Risk-Centric Model of Demand Recessions and Speculation* |
title_full_unstemmed | A Risk-Centric Model of Demand Recessions and Speculation* |
title_short | A Risk-Centric Model of Demand Recessions and Speculation* |
title_sort | risk centric model of demand recessions and speculation |
url | https://hdl.handle.net/1721.1/144451 |
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