A model of asset price spirals and aggregate demand amplification of a "Covid-19" shock

Author / Creator

Caballero, Ricardo J. author

Available as

Online

Summary

We provide a model of endogenous asset price spirals and severe aggregate demand contractions following a large supply shock. The key mechanism stems from the drop in the wealth share of the econom...

We provide a model of endogenous asset price spirals and severe aggregate demand contractions following a large supply shock. The key mechanism stems from the drop in the wealth share of the economy's risk-tolerant agents: as a recessionary supply shock hits the economy, their wealth declines and their leverage rises endogenously, causing them to offload some risky assets. When monetary policy is unconstrained, it can offset the decline in risk tolerance with an interest rate cut that boosts the market's Sharpe ratio. However, if the interest rate policy is constrained, new contractionary feedbacks arise: recessionary supply shocks not only feed into reduced risk tolerance but also into further asset price and output drops, which feed the risk-off episode and trigger a downward loop. When pre-shock leverage ratios are high, multiple equilibria are possible, including one where risk-tolerant agents go bankrupt. A large-scale asset purchases (LSAPs) policy can be highly effective in this environment, as it reverses the downward asset price spiral. The Covid-19 shock and the large response by all the major central banks provide a vivid illustration of the environment we seek to capture.

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