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Policy design in a model with swings in risk appetite

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  • De Paoli, Bianca
  • Zabczyk, Pawel

Abstract

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.

Suggested Citation

  • De Paoli, Bianca & Zabczyk, Pawel, 2012. "Policy design in a model with swings in risk appetite," LSE Research Online Documents on Economics 51517, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:51517
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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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