Portfolio Inertia and the Equity Premium

Abstract

We develop a DSGE model in which aggregate shocks induce endogenous movements in risk. The key feature of our model is that households rebalance their financial portfolio allocations infrequently, as they face a fixed cost of transferring cash across accounts. We show that the model can account for the mean returns on equity and the risk-free rate, and generates countercyclical movements in the equity premium that help explain the response of stock prices to monetary shocks. The model is consistent with empirical evidence documenting that unanticipated changes in monetary policy have important effects on equity prices through changes in risk.

Keywords: Limited financial market participation, infrequent portfolio adjustment, equity premium

JEL Classification: E32, E44