A Risk-Centric Model of Demand Recessions and Speculation*

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 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.

Five Facts about Beliefs and Portfolios

“…We also contribute to a macro-finance literature that has debated the tradeoffs between behavioral and rational modeling approaches, with survey evidence providing an important input (see Cochrane, 2011Cochrane, , 2017Greenwood and Shleifer, 2014;Adam, Matveev and Nagel, 2018). Among the many proposed equilibrium models, the most relevant for our work are those that directly incorporate survey evidence (e.g., Barberis et al, 2015;Adam, Marcet and Beutel, 2017;Bhandari, Borovička and Ho, 2016) and those that feature heterogeneous belief (e.g., Scheinkman and Xiong, 2003;Geanakoplos, 2010;Caballero and Simsek, 2017;Martin and Papadimitriou, 2019).…”

Liquidity Provision and Financial Stability

“…Brunnermeier and Sannikov (2014) and He and Krishnamurthy (2012), ,2013), ,2019a) demonstrate the ability of globally solved nonlinear continuous‐time models to explain financial crises and to evaluate policies that target financial stability. Caballero and Simsek (2020), ,2019) extend these tools so that they are tractable enough for use in analytical models. Additional work in this field include Adrian and Boyarchenko (2012), Maggiori (2017), Di Tella (2017), and Van der Ghote (2019).…”

Macroprudential Policy, House Price Fluctuation and Household Consumption

“…Therefore, the cycle of house prices and consumption growth is closely synchronized (Aoki et al, 2004;Attanasio et al, 2005;Katagiri, 2018). However, high house prices are often tied to financial systemic risk (Caballero & Simsek, 2020). In the cycle of rising house prices, there are asset bubbles, bloats, and bursts.…”

“…Through the research of the dynamic stochastic general equilibrium model, it has been found that the macroprudential policy and monetary policy implemented by the Central Bank can effectively improve the welfare level of citizens when the negative impact occurs in the economy (Caballero & Simsek, 2020). The level of welfare depends on the level of household consumption.…”