Risk Premium Shifts and Monetary Policy: A Coordination Approach

Abstract

We explore a global game model of the impact of monetary policy shocks. Risk-neutral asset managers interact with risk-averse households in a market with a risky bond and a floating rate money market fund. Asset managers are averse to coming last in the ranking of short-term performance. This friction injects a coordination element in asset managers’ portfolio choice that leads to large jumps in risk premiums in response to small future anticipated changes in central bank policy rates. The size of the asset management sector is the key parameter determining the extent of market disruption to monetary policy shocks.

Keywords: market liquidity, risk-taking channel, runs

JEL Classification: E43, E52, E58