Ricardo J. Caballero, Alp Simsek

Bibliographic Information

NBER Working Paper No. 27044
Issued in April 2020, Revised in May 2020
NBER Program(s):AP, EFG, ME

This paper was revised on May 26, 2020

Available Formats


We provide a model of endogenous asset price spirals and severe aggregate demand contractions following a large real (non-financial) shock. The key mechanism stems from the drop in the wealth share of the economy's risk-tolerant agents: as a recessionary shock hits the economy, their wealth declines and their leverage rises endogenously, causing them to o­ oad 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 shocks not only lead to reduced risk tolerance but also to 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. In an extension, we show how corporate debt overhang problems exacerbate our mechanism. 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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