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Monetary Policy and the Cyclicality of Risk

  • Gust, Christopher
  • López-Salido, J David

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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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7727.

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Date of creation: Mar 2010
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Handle: RePEc:cpr:ceprdp:7727
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