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Model misspecification, the equilibrium natural interest rate and the equity premium

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  • Tristani, Oreste

Abstract

This paper analyses the determinants of the natural rate of interest in a non-linear model where agents are uncertain over both future technology growth and the future course of monetary policy. I show that the real natural rate can be affected by sizable uncertainty premia, including premia associated with monetary un-certainty. This result is potentially problematic for both the estimation of the natural rate and its use as a policy indicator. Monetary uncertainty can also contribute to amplify the equity premium, and to account for its apparent, positive link with inflation. JEL Classification: E43, G11

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0808.

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Date of creation: Sep 2007
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Handle: RePEc:ecb:ecbwps:20070808

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Keywords: equity premium puzzle; model misspecification; Natural rate of interest; risk-free rate puzzle; robust control;

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References

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  1. Buraschi, Andrea & Jiltsov, Alexei, 2005. "Inflation risk premia and the expectations hypothesis," Journal of Financial Economics, Elsevier, vol. 75(2), pages 429-490, February.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper Series WP-01-08, Federal Reserve Bank of Chicago.
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  13. Andrew B. Abel, 2001. "An Exploration of the Effects of Pessimism and Doubt on Asset Returns," NBER Working Papers 8132, National Bureau of Economic Research, Inc.
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  15. Fagan, Gabriel & Henry, Jérôme & Mestre, Ricardo, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 0042, European Central Bank.
  16. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  17. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
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  19. Pamela Labadie, 1989. "Stochastic inflation and the equity premium," Discussion Paper / Institute for Empirical Macroeconomics 12, Federal Reserve Bank of Minneapolis.
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Cited by:
  1. Lioui, Abraham & Poncet, Patrice, 2012. "On model ambiguity and money neutrality," Journal of Macroeconomics, Elsevier, vol. 34(4), pages 1020-1033.

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