A Risk-centric Model of Demand Recessions and Macroprudential Policy
NBER Working Paper No. 23614
When investors are unwilling to hold the economy’s risk, a decline in the interest rate in- creases the Sharpe ratio of the market and equilibrates the risk markets. If the interest rate is constrained from below, risk markets are instead equilibrated via a decline in asset prices. How- ever, the latter drags down aggregate demand, which further drags prices down, and so on. If investors are pessimistic about the recovery, the economy becomes highly susceptible to down- ward spirals due to dynamic feedbacks between asset prices, aggregate demand, and growth. In this context, belief disagreements generate highly destabilizing speculation that motivates macroprudential policy.
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Document Object Identifier (DOI): 10.3386/w23614