Monetary Policy and the Cyclicality of Risk
International Finance Discussion Paper No. 999
38 Pages Posted: 24 Jul 2010
There are 2 versions of this paper
Monetary Policy and the Cyclicality of Risk
Monetary Policy and the Cyclicality of Risk
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: Suggested Citation
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