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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. Aubhik Khan & Julia Thomas, 2007. "Inflation and interest rates with endogenous market segmentation," Working Papers 07-1, Federal Reserve Bank of Philadelphia.
  2. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, October.
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  17. Yannis Bilias & Dimitris Georgarakos & Michael Haliassos, 2010. "Portfolio Inertia and Stock Market Fluctuations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(4), pages 715-742, 06.
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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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