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Cyclical Risk Aversion, Precautionary Saving and Monetary Policy

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  • Bianca De Paoli
  • Pawel Zabczyk

Abstract

This paper analyzes the conduct of monetary policy in an environment in which cyclical swings in risk appetite affect households' propensity to save. It uses a New-Keynesian model featuring external habit formation to show that taking note of precautionary saving motives justifies an accommodative policy bias in the face of persistent, adverse disturbances. Equally, policy should be more restrictive - i.e. `lean against the wind' - following positive shocks. Since the size of these `risk-adjustments' is increasing in the degree of macroeconomic volatility, ignoring this channel could lead to larger policy errors in turbulent times - with good luck translating into good policy.

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Bibliographic Info

Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1132.

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Date of creation: Mar 2012
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Handle: RePEc:cep:cepdps:dp1132

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Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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Keywords: precautionary saving; monetary policy; cyclical risk aversion; macro-finance; non-linearities;

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References

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  1. Ravenna , Federico & Seppälä , Juha, 2006. "Monetary policy and rejections of the expectations hypothesis," Research Discussion Papers 25/2006, Bank of Finland.
  2. Cochrane, John H. & Campbell, John, 1999. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Scholarly Articles 3119444, Harvard University Department of Economics.
  3. Pierpaolo Benigno & Michael Woodford, 2005. "Inflation Stabilization And Welfare: The Case Of A Distorted Steady State," Journal of the European Economic Association, MIT Press, vol. 3(6), pages 1185-1236, December.
  4. Glenn D. Rudebusch & Eric T. Swanson, 2008. "Examining the bond premium puzzle with a DSGE model," Working Paper Series 2007-25, Federal Reserve Bank of San Francisco.
  5. Sydney C. Ludvigson & Alexander Michaelides, 2001. "Does Buffer-Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?," American Economic Review, American Economic Association, vol. 91(3), pages 631-647, June.
  6. Juan F. Rubio-Ramirez & Jesus Fernández-Villaverde, 2005. "Estimating dynamic equilibrium economies: linear versus nonlinear likelihood," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 20(7), pages 891-910.
  7. Hördahl, Peter & Tristani, Oreste & Vestin, David, 2007. "The yield curve and macroeconomic dynamics," Working Paper Series 0832, European Central Bank.
  8. Juillard, Michel & Karam, Philippe & Laxton, Douglas & Pesenti, Paolo, 2006. "Welfare-based monetary policy rules in an estimated DSGE model of the US economy," Working Paper Series 0613, European Central Bank.
  9. De Paoli, Bianca & Zabczyk, Pawel, 2009. "Why do risk premia vary over time? A theoretical investigation under habit formation," Bank of England working papers 361, Bank of England.
  10. Floden, Martin, 2005. "Aggregate Savings When Individual Income Varies," Working Paper Series in Economics and Finance 591, Stockholm School of Economics.
  11. Mark Kazarosian, 1993. "Precautionary Savings- A Panel Study," Boston College Working Papers in Economics 247, Boston College Department of Economics.
  12. Huggett, Mark & Ospina, Sandra, 2001. "Aggregate precautionary savings: when is the third derivative irrelevant?," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 373-396, October.
  13. Martin Møller Andreasen, 2008. "Explaining Macroeconomic and Term Structure Dynamics Jointly in a Non-linear DSGE Model," CREATES Research Papers 2008-43, School of Economics and Management, University of Aarhus.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Risk Aversion and the Natural Interest Rate
    by Blog Author in Liberty Street Economics on 2014-07-16 11:00:00
  2. 'Risk Aversion and the Natural Interest Rate'
    by Mark Thoma in Economist's View on 2014-07-16 08:21:30
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Cited by:
  1. Hatcher, Michael, 2011. "Time-varying volatility, precautionary saving and monetary policy," Bank of England working papers 440, Bank of England.
  2. Andersson, Magnus & D’Agostino, Antonello & de Bondt, Gabe & Roma, Moreno, 2011. "The predictive content of sectoral stock prices: a US-euro area comparison," Working Paper Series 1343, European Central Bank.
  3. Hatcher, Michael, 2013. "The Inflation Risk Premium on Government Debt in an Overlapping Generations Model," SIRE Discussion Papers 2013-81, Scottish Institute for Research in Economics (SIRE).

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