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The Tail that Keeps the Riskless Rate Low

Julian Kozlowski, Laura Veldkamp, Venky Venkateswaran


This chapter is a preliminary draft unless otherwise noted. It may not have been subjected to the formal review process of the NBER. This page will be updated as the chapter is revised.

Chapter in forthcoming NBER book NBER Macroeconomics Annual 2018, volume 33, Martin Eichenbaum and Jonathan A. Parker, editors
Conference held April 12-13, 2018
Forthcoming from University of Chicago Press
in NBER Book Series NBER Macroeconomics Annual

Riskless interest rates fell in the wake of the financial crisis and have remained low. We explore a simple explanation: This recession was perceived as an extremely unlikely event before 2007. Observing such an episode led all agents to re-assess macro risk, in particular, the probability of tail events. Since changes in beliefs endure long after the event itself has passed, perceived tail risk remains high, generates a demand for riskless, liquid assets, and continues to depress the riskless rate. We embed this mechanism in a simple production economy with liquidity constraints and use observable macro data, along with standard econometric tools, to discipline beliefs about the distribution of aggregate shocks. When agents observe an extreme, adverse realization, they re-estimate the distribution and attach a higher probability to such events recurring. As a result, even transitory shocks have persistent effects because, once observed, the shock stays forever in the agents' data set. We show that our belief revision mechanism can help explain the persistent nature of the fall in the risk-free rates.

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This chapter first appeared as NBER working paper w24362, The Tail that Keeps the Riskless Rate Low, Julian Kozlowski, Laura Veldkamp, Venky Venkateswaran
Commentary on this chapter:
  Comment, Fran├žois Gourio
  Comment, Robert E. Hall
  Discussion,
 
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