When investors are unwilling to hold the economy's risk, equilibrium in asset markets is typically restored through a decline in interest rates. If interest rates are constrained from below (the zero lower bound), falling risk appetite instead entails asset price declines that drag down aggregate demand, which then further depresses asset prices. Output and risk gaps emerge side by side and reinforce each other. These mechanisms seem to have played out forcefully at various times in the past, notably during the Great Financial Crisis. Yet, in mainstream macroeconomic models, the focus is exclusively on the output gap component, while the risk gap component plays only a secondary role, if any.
This paper develops a macro-finance model that features mutually reinforcing feedback loops between the output and risk gaps. The model incorporates aggregate demand channels and investor speculation arising from disagreement in beliefs about economic prospects. Volatility shocks generate time-varying risk premia while the interest rate is constrained by the zero lower bound. As a result, mutually reinforcing feedback loops between asset prices and output demand can ensue in case of a negative financial shock. The share of optimistic investors is a key stabilising factor in a downswing, as it limits the scope for asset price declines.
The paper demonstrates how the zero lower bound on interest rates can constrain the capacity of monetary policy to stabilise asset markets and the economy in the case of an adverse financial shock. Macroprudential policy that curbs speculation by optimistic investors in the boom can mitigate downward spirals in the bust as it safeguards optimistic investors from suffering heavy losses during downturns, thus preserving their stabilising role.
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.
JEL classification: E00, E12, E21, E22, E30, E40, G00, G01, G11
Keywords: risk gap, output gap, risk-premium shocks, aggregate demand, liquidity trap,"rstar", Sharpe ratio, monetary and macroprudential policy, heterogeneous beliefs, speculation, endogenous volatility
Read the full paper at: https://www.bis.org/publ/work733.htm