A Model of Endogenous Risk Intolerance and LSAPs: Asset Prices and Aggregate Demand in a "COVID-19" Shock. (5th April 2021)

• Record Type: Journal Article
• Authors: Caballero, Ricardo J; Simsek, Alp
• Editors: Koijen, Ralph
• Is Part Of: Review of financial studies. Volume 34:Number 11(2021)
• Page Start: 5522
• Page End: 5580
• Publication Date: 2021-04-05
• Subjects: E30 -- E40 -- E50 -- G01 -- G10 -- G20; Finance -- United States -- Periodicals; Finance -- Periodicals; 332
• DOI: 10.1093/rfs/hhab036
• Languages: English
• ISSNs: 0893-9454

Abstract

Abstract: We theoretically investigate the interaction of endogenous risk intolerance and monetary policy following a large recessionary shock. As asset prices dip, risk-tolerant agents' wealth share declines. This decline reduces the market's risk tolerance and triggers a downward loop in asset prices and aggregate demand when the interest rate policy is constrained. In this context, large-scale asset purchases are effective because they transfer unwanted risk to the government's balance sheet. These effects are sizable when the model is calibrated to match the estimates of aggregate asset demand inelasticity. The COVID-19 shock illustrates the environment we seek to capture.