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Model misspecification, the equilibrium natural interest rate and the equity premium

  • Tristani, Oreste

This paper analyses the determinants of the natural rate of interest in a non-linear model where agents are uncertain over both future technology growth and the future course of monetary policy. I show that the real natural rate can be affected by sizable uncertainty premia, including premia associated with monetary un-certainty. This result is potentially problematic for both the estimation of the natural rate and its use as a policy indicator. Monetary uncertainty can also contribute to amplify the equity premium, and to account for its apparent, positive link with inflation. JEL Classification: E43, G11

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Paper provided by European Central Bank in its series Working Paper Series with number 0808.

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Date of creation: Sep 2007
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Handle: RePEc:ecb:ecbwps:20070808
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  1. Stulz, ReneM., 1986. "Interest rates and monetary policy uncertainty," Journal of Monetary Economics, Elsevier, vol. 17(3), pages 331-347, May.
  2. Thomas Laubach & John C. Williams, 2001. "Measuring the natural rate of interest," Finance and Economics Discussion Series 2001-56, Board of Governors of the Federal Reserve System (U.S.).
  3. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  4. Abel, Andrew B., 2002. "An exploration of the effects of pessimism and doubt on asset returns," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1075-1092, July.
  5. Pamela Labadie, 1989. "Stochastic inflation and the equity premium," Discussion Paper / Institute for Empirical Macroeconomics 12, Federal Reserve Bank of Minneapolis.
  6. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
  7. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
  8. Athanasios Orphanides & John C. Williams, 2002. "Robust monetary policy rules with unknown natural rates," Working Paper Series 2003-01, Federal Reserve Bank of San Francisco.
  9. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  10. Marc P. Giannoni, 2007. "Robust optimal monetary policy in a forward-looking model with parameter and shock uncertainty," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(1), pages 179-213.
  11. Rebelo, Sergio & Xie, Danyang, 1999. "On the optimality of interest rate smoothing," Journal of Monetary Economics, Elsevier, vol. 43(2), pages 263-282, April.
  12. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  13. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1998. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good To Be True?," NBER Working Papers 6354, National Bureau of Economic Research, Inc.
  14. Fuhrer, Jeffrey C & Moore, George R, 1995. "Forward-Looking Behavior and the Stability of a Conventional Monetary Policy Rule," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1060-70, November.
  15. Pascal J. Maenhout, 2004. "Robust Portfolio Rules and Asset Pricing," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 951-983.
  16. Buraschi, Andrea & Jiltsov, Alexei, 2005. "Inflation risk premia and the expectations hypothesis," Journal of Financial Economics, Elsevier, vol. 75(2), pages 429-490, February.
  17. Olivier J. Blanchard, 1993. "Movements in the Equity Premium," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(2), pages 75-138.
  18. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  19. Fagan, Gabriel & Henry, Jérôme & Mestre, Ricardo, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 0042, European Central Bank.
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