- A Model of Asset Price Spirals and Aggregate Demand Amplification of a ＂Covid-19＂ Shock
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 offload 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.