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Monetary policy and the cyclicality of risk

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  • Christopher Gust
  • David Lopez-Salido

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 microfinance literature, variation in risk arises because households face fixed costs of transferring cash across financial accounts, implying that some households rebalance 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 countercyclical monetary policy generates higher average welfare than constant money growth or zero inflation policies.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 999.

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Date of creation: 2010
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Handle: RePEc:fip:fedgif:999

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Keywords: Monetary policy;

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  1. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1.
  2. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
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  4. Bilias, Yannis & Georgarakos, Dimitris & Haliassos, Michael, 2006. "Portfolio inertia and stock market fluctuations," CFS Working Paper Series 2006/14, Center for Financial Studies (CFS).
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  6. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  7. Francisco Palomino, 2012. "Bond Risk Premiums and Optimal Monetary Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(1), pages 19-40, January.
  8. Ben S. Bernanke & Kenneth N. Kuttner, 2004. "What explains the stock market's reaction to Federal Reserve policy?," Finance and Economics Discussion Series 2004-16, Board of Governors of the Federal Reserve System (U.S.).
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  12. John Ammer & Clara Vega & Jon Wongswan, 2008. "Do fundamentals explain the international impact of U.S. interest rates? evidence at the firm level," International Finance Discussion Papers 952, Board of Governors of the Federal Reserve System (U.S.).
  13. Jonathan A. Parker & Annette Vissing-Jorgensen, 2009. "Who Bears Aggregate Fluctuations and How?," NBER Working Papers 14665, National Bureau of Economic Research, Inc.
  14. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  15. Fatih Guvenen, 2009. "A Parsimonious Macroeconomic Model for Asset Pricing," NBER Working Papers 15243, National Bureau of Economic Research, Inc.
  16. Julia Thomas & Aubhik Khan, 2012. "Inflation and Interest Rates with Endogenous Market Segmentation," 2012 Meeting Papers 1070, Society for Economic Dynamics.
  17. Yosef Bonaparte & Russell Cooper, 2009. "Costly Portfolio Adjustment," NBER Working Papers 15227, National Bureau of Economic Research, Inc.
  18. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity Premium Puzzle," Harvard Institute of Economic Research Working Papers 1947, Harvard - Institute of Economic Research.
  19. Ehrmann, Michael & Fratzscher, Marcel, 2004. "Taking stock: monetary policy transmission to equity markets," Working Paper Series 0354, European Central Bank.
  20. Robert E. Hall, 2009. "Reconciling Cyclical Movements in the Marginal Value of Time and the Marginal Product of Labor," Journal of Political Economy, University of Chicago Press, vol. 117(2), pages 281-323, 04.
  21. Markus K. Brunnermeier & Stefan Nagel, 2006. "Do Wealth Fluctuations Generate Time-varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation," NBER Working Papers 12809, National Bureau of Economic Research, Inc.
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  1. Monetary policy and the cyclicality of risk
    by Christian Zimmermann in NEP-DGE blog on 2010-08-17 14:28:19

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