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A Risk-centric Model of Demand Recessions and Speculation

Ricardo J. Caballero, Alp Simsek

NBER Working Paper No. 23614
Issued in July 2017, Revised in February 2020
NBER Program(s):Asset Pricing, Corporate Finance, Economic Fluctuations and Growth, International Finance and Macroeconomics, Monetary Economics

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 macro- economic 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 not only because they affect asset valuations but also because they 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.

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Document Object Identifier (DOI): 10.3386/w23614

Published: Ricardo J Caballero & Alp Simsek, 2020. "A Risk-Centric Model of Demand Recessions and Speculation*," The Quarterly Journal of Economics, vol 135(3), pages 1493-1566. citation courtesy of

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