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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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Bibliographic Info

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. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  2. Ben S. Bernanke & Kenneth N. Kuttner, 2003. "What explains the stock market's reaction to Federal Reserve policy?," Staff Reports 174, Federal Reserve Bank of New York.
  3. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  4. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2002. "Money, Interest Rates, and Exchange Rates with Endogenously Segmented Markets," Journal of Political Economy, University of Chicago Press, vol. 110(1), pages 73-112, February.
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  18. 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.).
  19. Ehrmann, Michael & Fratzscher, Marcel, 2004. "Taking stock: monetary policy transmission to equity markets," Working Paper Series 0354, European Central Bank.
  20. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1.
  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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