Risk Markets Imbalances and Macroeconomics

Massachusetts Institute Of Technology, Cambridge MA

Investigators

Abstract

Abstract This project explores how changes in the demand and supply for risky assets and the imbalance between them (risk-market imbalances) affect macroeconomic outcomes. The research then considers efficient macroeconomic policy from this perspective. This research is highly relevant in the recent low interest rate environment, as monetary policy has historically been the most direct tool to prevent severe risk-markets shocks from spilling over to the real economy. When interest rates are low, traditional policies are ineffective. Furthermore, a low interest rate environment encourages speculative bubbles and high yield investment patterns that make the economy more vulnerable. These phenomena and policy responses to them impact the global economy and require an internationally coordinated response. This research will generate new analytical tools to integrate financial and macroeconomic analysis. It will also explore optimal policy responses to macroeconomic outcomes by considering the impact of risk-market imbalances on the real economy. This project examines the interactions between risk-shocks and constraints on monetary policy in generating economic fluctuations, the role of financial speculation and its drivers in exacerbating the severity of these fluctuations, and the optimal joint monetary, fiscal, and macroprudential policy framework for this environment. Specifically, the research examines risk-off episodes with a zero-lower bound (ZLB) on interest rates that incorporates a broader set of constraints, including political economy concerns. The research will also explore, both theoretically and empirically, the role of leverage and how it responds to different policy frameworks. The project further incorporates speculative bubbles and behavioral elements in this framework. On the international front, the research will develop and test models of gross capital flows and exchange rate movements during both global and local risk-off episodes. The project will then explore optimal international coordination mechanisms to deal with global cycles in a low interest rate environment. This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.