Working Paper

A Theory of Safe Asset Creation, Systemic Risk, and Aggregate Demand

Abstract: This paper presents a theory of safe asset creation and the interactions between systemic risk and aggregate demand. The creation of private safe assets by financial intermediaries requires them to take leverage, which generates a risk of future crisis (systemic risk) in which intermediaries liquidate assets to service their debt. In contrast, the creation of public safe assets by the government does not generate systemic risk as the government's power to tax allows it to better absorb losses. The level of systemic risk determines the neutral rate of interest through households' precautionary saving and aggregate demand. The model features a two-way interaction between systemic risk and aggregate demand. Monetary and fiscal policy can stabilize aggregate demand and reduce systemic risk by altering the mix of private and public safe assets held by savers. When monetary policy is constrained, the economy can enter a risk-driven stagnation trap in which economic stagnation arises due to excessive systemic risk. Macroprudential policies which reduce systemic risk can stimulate aggregate demand.

Keywords: Financial crises; Safe assets; Systemic risk; Fiscal policy; Macroprudential policy; Unconventional monetary policy; Demand-driven recession;

JEL Classification: E44; G01; G21; E58; G28; G18;

https://doi.org/10.17016/FEDS.2023.062

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2023-09-22

Number: 2023-062