A Risk-centric Model of Demand Recessions and Macroprudential Policy
A productive capacity generates output and risks, both of which need to be absorbed by economic agents. If they are unable to do so, output and risk gaps emerge. Risk gaps close quickly: A decline in the interest rate increases the Sharpe ratio of the risky assets and equilibrates the risk markets. If the interest rate is constrained from below (or the policy response is slow), the risk markets are instead equilibrated via a decline in asset prices. However, the drop in asset prices also drags down aggregate demand and generates a recession, which further drags prices down, and so on. If economic agents are optimistic about the speed of recovery, a decline in asset prices leads to a large increase in the Sharpe ratio that stabilizes the drop. If they are pessimistic, the economy becomes highly susceptible to downward spirals due to the feedback between asset prices and aggregate demand. The fear of a recession with a downward price spiral also reduces the interest rate during the boom. When beliefs are heterogenous, optimists take too much risk from a social point of view since they do not internalize their positive effect on asset prices and aggregate demand during recessions. Macroprudential policy can improve outcomes, and is procyclical as the negative aggregate demand effect of prudential tightening is more easily offset by interest rate policy during booms than during recessions. Forward guidance policies are also effective, but their robustness weakens as agents become more pessimistic. Our model also illustrates that interest rate rigidities and speculation generate endogenous price volatility that exacerbates demand recessions.
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Document Object Identifier (DOI): 10.3386/w23614