The Risk Channel of Unconventional Monetary Policy

Abstract

This paper examines how unconventional monetary policy affects asset prices and macroeconomic conditions by reallocating risk in the economy. I consider an environment with two main ingredients: heterogeneity in risk tolerance and limited asset market participation. Risk-tolerant investors take leveraged positions, exposing the economy to balance sheet recessions. Limited asset market participation implies the balance sheet of the central bank is non-neutral. Unconventional monetary policy reduces the risk premium and endogenous volatility. During balance sheet recessions, asset purchases boost investment and growth. In contrast, during normal times, the expectation of future interventions reduces growth by its impact on savings. A commitment by the central bank to unwind its portfolio early, conditional on the recovery of leveraged institutions’ balance sheet, reduces the risk premium by more than strategies involving holding its portfolio for longer. Asset purchases also have implications for the concentration of risk. Leveraged institutions respond to the policy by reducing risk-taking relatively more than risk-averse investors. As risk concentration falls, the probability of negative tail-events is reduced, enhancing financial stability. ∗I am extremely grateful to Leonid Kogan, Alp Simsek, Robert Townsend and Ivan Werning for invaluable guidance and support. I also thank Rodrigo Adao, George-Marios Angeletos, Nicolas Caramp, Ricardo Caballero, Victor Duarte, Ernest Liu, Juan Passadore, Matthew Rognlie, Andres Sarto, Ludwig Straub, as well as seminar participants at the MIT Macro Lunch and the MIT Finance Lunch. I thank the Macro Financial Modeling (MFM) group for financial support. †Massachusetts Institute of Technology, Department of Economics. Email: dejanir@mit.edu

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