Asset Prices, Tail Risks and the Macroeconomy

In this paper I study how movements in risk premia, and not fundamentals, affect asset prices and, in turn, how those feed back to the real side of the economy. To do so, I use a model in the same spirit of Caballero and Simsek (2020), where the amount of risk in the economy is endogenously determined and crucially depends on speculators' beliefs. The main innovation is in modelling speculators' belief to accommodate the presence of tail risks and extreme events. The presence of tail risks implies a persistent downward pressure on risky asset prices and safe yields. I then study the optimal stabilization strategy from the perspective of monetary policy.