Fisherian Asset Price Deflation and the Zero Lower Bound

Cao, Dân; Luo, Wenlan; Nie, Guangyu

doi:10.2139/ssrn.3531341

Cited by 4 publications

(2 citation statements)

References 39 publications

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“…Also related isCaballero and Krishnamurthy (2009), who show how the endogenous leverage of the US economy caused by the global demand for safe assets creates instability with respect to supply shocks. See alsoKiyotaki and Moore (1997);Beaudry and Lahiri (2014); Di Tella (2017);Cao et al (2019).…”

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confidence: 99%

A Model of Endogenous Risk Intolerance and LSAPs: Asset Prices and Aggregate Demand in a “COVID-19” Shock

Caballero

Simsek

2021

The Review of Financial Studies

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We theoretically investigate the interaction of endogenous risk intolerance and monetary policy following a large recessionary shock. As asset prices dip, risk-tolerant agents’ wealth share declines. This decline reduces the market’s risk tolerance and triggers a downward loop in asset prices and aggregate demand when the interest rate policy is constrained. In this context, large-scale asset purchases are effective because they transfer unwanted risk to the government’s balance sheet. These effects are sizable when the model is calibrated to match the estimates of aggregate asset demand inelasticity. The COVID-19 shock illustrates the environment we seek to capture.

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confidence: 99%

A Model of Endogenous Risk Intolerance and LSAPs: Asset Prices and Aggregate Demand in a “COVID-19” Shock

Caballero

Simsek

2021

The Review of Financial Studies

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“…See alsoKiyotaki and Moore (1997);Shleifer and Vishny (1997);Lorenzoni (2008); Geanakoplos (2010); Adrian and Shin (2010);Beaudry and Lahiri (2014); Di Tella (2017);Dávila and Korinek (2018);Cao et al (2019).…”

mentioning

confidence: 99%

A Model of Endogenous Risk Intolerance and LSAPs: Asset Prices and Aggregate Demand in a “Covid-19” Shock

Caballero

Simsek

2020

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In this paper we: (i) provide a model of the endogenous risk intolerance and severe aggregate demand contractions following a large real (non-financial) shock; and (ii) demonstrate the effectiveness of Large Scale Asset Purchases (LSAPs) in addressing these contractions. The key mechanism stems from heterogeneous risk tolerance: as a recessionary shock hits the economy and brings down asset prices, risk-tolerant agents' wealth share declines and their leverage rises endogenously. This reduces the market's risk tolerance and generates downward pressure on asset prices and aggregate demand. When monetary policy is unconstrained, it can offset the decline in risk tolerance with an interest rate cut that boosts the market's Sharpe ratio. However, if the interest rate policy is constrained, new contractionary feedbacks arise: recessionary shocks lead to further asset price and output drops, which feed the risk-off episode and trigger a downward loop. In this context, LSAPs improve asset prices and aggregate demand by transferring risk to the government's balance sheet, which reduces the market's required Sharpe ratio. Optimal LSAPs are larger when the (consolidated) government has greater future fiscal capacity and the downward spiral is more severe. In an extension, we show how corporate debt overhang problems strengthen our mechanisms. The Covid-19 shock and the large response by all the major central banks provide a vivid illustration of the environment we seek to capture.

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