A Risk-Centric Model of Demand Recessions and Macroprudential Policy

Abstract

We theoretically analyze the interactions between asset prices, …nancial speculation, and macroeconomic outcomes when output is determined by aggregate demand. If the interest rate is constrained, a rise in the risk premium lowers asset prices and generates a demand recession. This reduces earnings and generates a feedback loop between asset prices and aggregate demand. The recession is exacerbated by speculation due to heterogeneous asset valuations during the ex-ante low-risk-premium period. Macroprudential policy that restricts speculation can Pareto improve welfare. We also provide empirical support for the mechanisms by comparing impulse responses to house price shocks within and outside the Eurozone.

Keywords: Risk premium shocks, asset prices, aggregate demand, interest rate rigidity booms and recessions, heterogeneous beliefs, speculation, monetary and macroprudential policy

JEL Classification: E00, E12, E21, E22, E30, E40, G00, G01, G11