DP13815 A Risk-centric Model of Demand Recessions and Speculation

Author(s): Ricardo Caballero, Alp Simsek
Publication Date: June 2019
Date Revised: February 2020
Keyword(s): aggregate demand, asset prices, belief disagreements, booms and recessions, extrapolation, interest rate rigidity, monetary and macroprudential policy, Speculation, Time-varying risk premium, Uncertainty shocks
JEL(s): E00, E12, E21, E22, E30, E40, G00, G01, G11
Programme Areas: Financial Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13815

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 macroeconomic 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.