Effective demand failures and the limits of monetary stabilization policy

Abstract

We theoretically investigate the interaction of endogenous risk intolerance and monetary policy following a large recessionary shock. As asset prices dip, risk-tolerant agents’ wealth share declines. This decline reduces the market’s risk tolerance and triggers a downward loop in asset prices and aggregate demand when the interest rate policy is constrained. In this context, large-scale asset purchases are effective because they transfer unwanted risk to the government’s balance sheet. These effects are sizable when the model is calibrated to match the estimates of aggregate asset demand inelasticity. The COVID-19 shock illustrates the environment we seek to capture.

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