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Monetary Policy, Velocity, and the Equity Premium

  • Gust, Christopher
  • López-Salido, J David

We develop a DSGE model in which monetary policy generates endogenous movements in risk. The key feature of our model is that households rebalance their financial portfolio allocations infrequently, as they face a fixed cost of transferring cash across accounts. We show that the model can account for the mean returns on equity and the risk-free rate,and generates countercyclical movements in the equity premium that help explain the response of stock prices to monetary shocks. While stimulative monetary policy can lower risk in equity markets, it is also associated with higher inflation expectations and inflation risk premia. The model gives rise to periods in which the zero lower bound constraint on the nominal interest rate binds and demand for liquidity jumps, leading to procyclical movements in velocity.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7388.

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Date of creation: Aug 2009
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Handle: RePEc:cpr:ceprdp:7388
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