Monetary Policy and the Cyclicality of Risk

International Finance Discussion Paper No. 999

38 Pages Posted: 24 Jul 2010

See all articles by Christopher Gust

Christopher Gust

Board of Governors of the Federal Reserve System

David Lopez-Salido

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: June 1, 2010

Abstract

We use a DSGE model that generates endogenous movements in risk premia to examine the positive and normative implications of alternative monetary policy rules. As emphasized by the micro-finance literature, variation in risk arises because households face fixed costs of transferring cash across financial accounts, implying that some households re-balance their portfolios infrequently. We show that the model can account for the mean returns on equity and the risk-free rate, and in line with empirical evidence generates a decline in the equity premium following an unanticipated easing of monetary policy. An important result that emerges from our analysis is that counter-cyclical monetary policy generates higher average welfare than constant money growth or zero inflation policies.

Keywords: limited financial market participation, equity premium, inflation targeting

JEL Classification: E32, E44

Suggested Citation

Gust, Christopher and Lopez-Salido, David, Monetary Policy and the Cyclicality of Risk (June 1, 2010). International Finance Discussion Paper No. 999, Available at SSRN: https://ssrn.com/abstract=1646567 or http://dx.doi.org/10.2139/ssrn.1646567

Christopher Gust (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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