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Policy Design in a Model with Swings in Risk Appetite

  • Bianca De Paoli
  • Pawel Zabczyk

This paper studies the policy implications of habits and cyclical changes in agents' appetite for risk-taking. To do so, it analyses the non-linear solution of a New Keynesian (NK) model, in which slow-moving habits help match the cyclical properties of risk-premia. Our findings suggest that the presence of habits and swings in risk appetite can materially affect policy prescriptions. As in Ljungqvist and Uhlig (2000), a counter-cyclical fiscal instrument can eliminate habit-related externalities. Alternatively, monetary policy can partially curb the associated overconsumption by responding to risk premia. Specifically, periods in which risk premia are elevated (compressed) merit a looser (tighter) policy stance. However, the associated welfare gains appear quantitatively small.

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File URL: http://cep.lse.ac.uk/pubs/download/dp1170.pdf
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Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1170.

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Date of creation: Oct 2012
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Handle: RePEc:cep:cepdps:dp1170
Contact details of provider: Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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