The Fear Economy: A Theory of Output, Interest, and Safe Assets

IMF Working Papers, September 9, 2022

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Canonical URL: The Fear Economy: A Theory of Output, Interest, and Safe Assets

Presents a fear theory of the economy based on the interplay between fear of rare disasters and the interest rate on safe assets.
Framework: studies macroeconomic consequences of government-administered interest rates in the neoclassical real business cycle model.
Mechanism:
- When the government can fix the safe real interest rate, the gap between the "sticky real safe rate" and the "neutral rate" generates aggregate distortions.
- An exogenous rise in fear increases demand for safe assets and lowers the neutral rate.
- If the central bank does not lower the safe rate by the same amount, savings rise, leading to a decline in consumption and aggregate demand.
- The mechanism works in reverse when fear falls.

A single fear factor can simultaneously:
- generate cross-correlations in output, labor, consumption, and investment consistent with the postwar US economy;
- generate variation in equity prices, bond prices, and a large risk premium consistent with asset pricing data.
Pages: 82
Volume: 2022
Issue: 175
Series: Working Paper No. 2022/175
DOI: https://doi.org/10.5089/9798400216084.001
Stock No: WPIEA2022175
ISBN: 9798400216084
ISSN: 1018-5941

(1) Actively regulating the safe interest rate (in both directions) can mitigate the fluctuations generated by fear cycles.
(2) Recessions will be deeper and longer when central banks accept the zero lower bound and are unwilling to use negative rates.
(3) A commitment to use negative rates in recessions—even if never implemented—raises both the short- and long-run real neutral rates, and moderates the business cycle.
(4) Counter-cyclical fiscal policy can act as disaster insurance and be expansionary by reducing fear.
(5) Quantitative easing can be narrowly effective only when fear is high at the lower bound.
(6) When fear is high, especially at the lower bound, policies that boost productivity also help fight recessions.

Monetary policy:
- Consider active regulation of the safe real interest rate to offset fear-driven distortions.
- Avoid rigid acceptance of the zero lower bound; maintaining the option of negative rates can raise neutral rates and moderate cycles.
- Quantitative easing has limited effectiveness except when fear is high and the economy is at the lower bound.
Fiscal policy:
- Counter-cyclical fiscal measures can serve as disaster insurance by reducing fear and thus be expansionary.
Structural policy:
- Policies that boost productivity can mitigate recessions when fear is elevated, particularly at the lower bound.

Subject: Consumption, Financial services, Interest rate floor, Monetary policy, National accounts, Output gap, Production, Yield curve, Zero lower bound
Keywords: business cycle model, business cycles, Consumption, fear, fear economy, fear factor, fear theory, Global, government-administered interest rates, interest, Interest rate floor, Output gap, safe assets, Yield curve, Zero lower bound

IMF Working Paper — Ruchir Agarwal, September 9, 2022. Publication details as listed above.