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The risk premium in New Keynesian DSGE models: The cost of inflation channel

Author

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  • Iania, Leonardo

    (Université catholique de Louvain, LIDAM/LFIN, Belgium)

  • Tretiakov, Pavel

    (Université catholique de Louvain, LIDAM/LFIN, Belgium)

  • Wouters, Rafael

    (National Bank of Belgium)

Abstract

We study the role of the cost of inflation channel in determining the risk premium in a (nonlinear) New Keynesian DSGE model. Relying on a Calvo (or Rotemberg) price setting, we show that while the cost of inflation channel generates the desired term premium moments, it suffers from nontrivial, counterintuitive approximation errors in the price dispersion function. In addition to documenting the issues, we propose ways to alleviate them, including a quasikinked demand function as a risk-generating mechanism.

Suggested Citation

  • Iania, Leonardo & Tretiakov, Pavel & Wouters, Rafael, 2023. "The risk premium in New Keynesian DSGE models: The cost of inflation channel," LIDAM Reprints LFIN 2023013, Université catholique de Louvain, Louvain Finance (LFIN).
    • Handle: RePEc:ajf:louvlr:2023013
    DOI: https://doi.org/10.1016/j.jedc.2023.104732
    Note: In: Journal of Economic Dynamics and Control, 2023, vol. 155, 104732
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    Cited by:

    1. Ales Marsal & Katrin Rabitsch & Lorant Kaszab, 2023. "From Linear to Nonlinear: Rethinking Inflation Dynamics in the Calvo Pricing Mechanism," Department of Economics Working Papers wuwp350, Vienna University of Economics and Business, Department of Economics.

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    More about this item

    Keywords

    Macro-finance ; DSGE ; Term premia;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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