As long as the central bank's main objective is to minimize the output gap (as is often stated), and asset prices influence aggregate demand with a lag (as is well documented), the central bank's optimal policy induces asset price overshooting in response to the emergence of an output gap. In fact, even if there is no output gap in the present but the central bank anticipates a weak recovery dragged down by insufficient demand, the optimal policy is to preemptively support asset prices today. This preemptive support is stronger if the acute phase of the recession is expected to be short lived. These dynamic aspects of optimal policy give rise to potentially large temporary gaps between the performance of asset prices and the real economy. One vivid example of this situation is the wide disconnect between the main stock market indices and the state of the real economy in the U.S. following the Fed's powerful response to the Covid-19 shock.
Caballero, R. and A. Simsek (2020), "Asset Prices and Aggregate Demand in a "Covid-19" Shock: A Model of Endogenous Risk Intolerance and LSAPs"
Previous title: A Model of Asset Price Spirals and Aggregate Demand Amplification of a "Covid-19'' Shock
[summary for VoxEU] [slides] [video for the online presentation at VMACS]
In this paper we: (i) provide a model of the endogenous risk intolerance and severe aggregate demand contractions following a large real (non-financial) shock; and (ii) demonstrate the effectiveness of Large Scale Asset Purchases (LSAPs) in addressing these contractions. The key mechanism stems from heterogeneous risk tolerance: as a recessionary shock hits the economy and brings down asset prices, risk-tolerant agents' wealth share declines and their leverage rises endogenously. This reduces the market's risk tolerance and generates downward pressure on asset prices and aggregate demand. 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 lead to further asset price and output drops, which feed the risk-off episode and trigger a downward loop. In this context, LSAPs improve asset prices and aggregate demand by transferring risk to the government's balance sheet, which reduces the market's required Sharpe ratio. Optimal LSAPs are larger when the (consolidated) government has greater future fiscal capacity and the downward spiral is more severe. In an extension, we show how corporate debt overhang problems strengthen our mechanisms. 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.
Caballero, R. and A. Simsek (2019), "Monetary Policy with Opinionated Markets" [slides]
Central banks (the Fed) and markets (the market) often disagree about the path of interest rates. We develop a model that explains this disagreement and study its implications for monetary policy and asset prices. We assume that the Fed and the market disagree about expected aggregate demand. Moreover, agents learn from data but not from each other---they are opinionated and information is fully symmetric. We then show that disagreements about future demand, together with learning, translate into disagreements about future interest rates. Moreover, these disagreements shape optimal monetary policy, especially when they are entrenched. The market perceives monetary policy "mistakes" and the Fed partially accommodates the market's view to mitigate the financial market fallout from perceived "mistakes." We also show that differences in the speed at which the Fed and the market react to the data---heterogeneous data sensitivity---matters for asset prices and interest rates. With heterogeneous data sensitivity, every macroeconomic shock has an embedded monetary policy "mistake" shock. When the Fed is more (less) data sensitive, the anticipation of these mistakes dampen (amplify) the impact of macroeconomic shocks on asset prices.
Chodorow-Reich, G., P. Nenov, and A. Simsek (2020), "Stock Market Wealth and the Real Economy: A Local Labor Market Approach"
We provide evidence of the stock market wealth effect on consumption by using a local labor market analysis and regional heterogeneity in stock market wealth. An increase in local stock wealth driven by aggregate stock prices increases local employment and payroll in nontradable industries and in total, while having no effect on employment in tradable industries. In a model with consumption wealth effects and geographic heterogeneity, these responses imply a marginal propensity to consume out of a dollar of stock wealth of 3.2 cents per year. We also use the model to quantify the aggregate effects of a stock market wealth shock when monetary policy is passive. A 20% increase in stock valuations, unless countered by monetary policy, increases the aggregate labor bill by at least 1.7% and aggregate hours by at least 0.75% two years after the shock.
Caballero, R. and A. Simsek (2019), "Prudential Monetary Policy"
[PDF--alternative to the Dropbox link] [Slides]
Should monetary policymakers raise interest rates during a boom to rein in financial excesses? We theoretically investigate this question using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, there are conditions under which small doses of prudential monetary policy (PMP) can provide financial stability benefits that are equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because higher asset prices support leveraged, high-valuation investors' balance sheets. The policy is most effective when the recession is more likely and leverage limits are neither too tight nor too slack. With shadow banks, whether PMP "gets in all the cracks" or not depends on the constraints faced by shadow banks.
We propose a tractable model of bargaining with optimism. The distinguishing feature of our model is that the bargaining power is durable and changes only due to important events such as elections. Players know their current bargaining powers, but they can be optimistic that events will shift the bargaining power in their favor. We define congruence (in political negotiations, political capital) as the extent to which a party's current bargaining power translates into its expected payoff from bargaining. We show that durability increases congruence and plays a central role in understanding bargaining delays, as well as the finer bargaining details in political negotiations. Optimistic players delay the agreement if durability is expected to increase in the future. The applications of this durability effect include deadline and election effects, by which upcoming deadlines or elections lead to ex-ante gridlock. In political negotiations, political capital is highest in the immediate aftermath of the election, but it decreases as the next election approaches.
Acemoglu, D. and A. Simsek (2012), "Moral Hazard and Efficiency in General Equilibrium with Anonymous Trading," working paper [slides]
A "folk theorem" maintains that competitive equilibria with asymmetric information are always (or generically) inefficient unless agents' consumption can be fully monitored by the principal (and specified in contracts). We critically evaluate these claims in the context of a general equilibrium economy with moral hazard. We allow agents' consumption to be partially monitored (e.g., employment contracts can specify how long a vacation agent takes, but not where she spends her vacation). We identify weak separability of agents' preferences between non-monitored consumption and effort as the necessary and sufficient condition for efficiency (e.g., weak separability implies how much the agent likes Bahamas vs. Hawaii is independent of her effort level). We also establish ε-efficiency when there are only small deviations from weak separability. These results delineate a range of benchmark environments under which general equilibrium has strong efficiency properties even though agents' consumption is not fully monitored.