Abstract We theoretically investigate the interaction of endogenous risk intolerance and monetary policy following a large recessionary shock. As asset prices dip, risk-tolerant agents’ wealth share declines. This decline reduces the market’s risk tolerance and triggers a downward loop in asset prices and aggregate demand when the interest rate policy is constrained. In this context, large-scale asset purchases are effective because they transfer unwanted risk to the government’s balance sheet. These effects are sizable when the model is calibrated to match the estimates of aggregate asset demand inelasticity. The COVID-19 shock illustrates the environment we seek to capture.

We provide evidence of the stock market consumption wealth effect by using a local labor market analysis. An increase in local stock wealth driven by aggregate stock prices increases local employment and payroll in nontradable industries and in total, with no effect on employment in tradable industries. In a model of geographic heterogeneity in stock wealth, these responses imply an MPC of 3.2 cents per year and that a 20 percent increase in stock valuations, unless countered by monetary policy, increases the aggregate labor bill by at least 1.7 percent and aggregate hours by at least 0.7 percent two years after the shock. (JEL E21, E24, E52, G12, G51, R22, R23 )