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A risk-centric model of demand recessions and macroprudential policy

Author

Listed:
  • Ricardo Caballero
  • Alp Simsek

Abstract

When investors are unwilling to hold the economy's risk, a decline in the interest rate increases 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. However, 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 downward spirals due to dynamic feedbacks between asset prices, aggregate demand, and potential growth. In this context, belief disagreements generate highly destabilizing speculation that motivates macroprudential policy.

Suggested Citation

  • Ricardo Caballero & Alp Simsek, 2018. "A risk-centric model of demand recessions and macroprudential policy," BIS Working Papers 733, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:733
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    References listed on IDEAS

    as
    1. Albagli, Elias & Ceballos, Luis & Claro, Sebastian & Romero, Damian, 2019. "Channels of US monetary policy spillovers to international bond markets," Journal of Financial Economics, Elsevier, vol. 134(2), pages 447-473.
    2. Fisher, Franklin M, 1969. "The Existence of Aggregate Production Functions," Econometrica, Econometric Society, vol. 37(4), pages 553-577, October.
    3. Fisher, Irving, 1907. "The Rate of Interest," History of Economic Thought Books, McMaster University Archive for the History of Economic Thought, number fisher1907.
    4. Avi J. Cohen, 2003. "Retrospectives: Whatever Happened to the Cambridge Capital Theory Controversies?," Journal of Economic Perspectives, American Economic Association, vol. 17(1), pages 199-214, Winter.
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    Cited by:

    1. Ricardo Caballero & Güneş Kamber, 2019. "On the global Impact of risk-off shocks and policy-put frameworks," BIS Working Papers 772, Bank for International Settlements.
    2. Phurichai Rungcharoenkitkul & Claudio Borio & Piti Disyatat Author-X-Name_First: Piti, 2019. "Monetary policy hysteresis and the financial cycle," BIS Working Papers 817, Bank for International Settlements.
    3. Mr. Niels-Jakob H Hansen & Signe Krogstrup, 2019. "Recent Shifts in Capital Flow Patterns in Korea: An Investor Base Perspective," IMF Working Papers 2019/262, International Monetary Fund.
    4. Sebastian Di Tella & Robert E. Hall, 2020. "Risk Premium Shocks Can Create Inefficient Recessions," NBER Working Papers 26721, National Bureau of Economic Research, Inc.
    5. Gadi Barlevy, 2018. "Bridging Between Policymakers’ and Economists’ Views on Bubbles," Economic Perspectives, Federal Reserve Bank of Chicago, issue 4, pages 1-21.

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    More about this item

    Keywords

    risk gap; output gap; risk-premium shocks; aggregate demand; liquidity trap; rstar; Sharpe ratio; monetary and macroprudential policy; heterogeneous beliefs; speculation; endogenous volatility;
    All these keywords.

    JEL classification:

    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General
    • G00 - Financial Economics - - General - - - General
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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