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Monetary policy and the cyclicality of risk

  • Christopher Gust
  • David Lopez-Salido

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 Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 999.

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Date of creation: 2010
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Handle: RePEc:fip:fedgif:999
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  1. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, January.
  2. Ricardo Reis, 2004. "Inattentive Consumers," NBER Working Papers 10883, National Bureau of Economic Research, Inc.
  3. John Ammer & Clara Vega & Jon Wongswan, 2008. "Do fundamentals explain the international impact of U.S. interest rates? evidence at the firm level," International Finance Discussion Papers 952, Board of Governors of the Federal Reserve System (U.S.).
  4. Jonathan A. Parker & Annette Vissing-Jorgensen, 2009. "Who Bears Aggregate Fluctuations and How?," NBER Working Papers 14665, National Bureau of Economic Research, Inc.
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  7. Ben S. Bernanke & Kenneth N. Kuttner, 2004. "What Explains the Stock Market's Reaction to Federal Reserve Policy?," NBER Working Papers 10402, National Bureau of Economic Research, Inc.
  8. Francisco Palomino, 2012. "Bond Risk Premiums and Optimal Monetary Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(1), pages 19-40, January.
  9. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2002. "Money, Interest Rates, and Exchange Rates with Endogenously Segmented Markets," Journal of Political Economy, University of Chicago Press, vol. 110(1), pages 73-112, February.
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  13. Fatih Guvenen, 2009. "A parsimonious macroeconomic model for asset pricing," Staff Report 434, Federal Reserve Bank of Minneapolis.
  14. Yannis Bilias & Dimitris Georgarakos & Michael Haliassos, 2010. "Portfolio Inertia and Stock Market Fluctuations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(4), pages 715-742, 06.
  15. Yosef Bonaparte & Russell Cooper, 2009. "Costly Portfolio Adjustment," NBER Working Papers 15227, National Bureau of Economic Research, Inc.
  16. Robert E. Hall, 2009. "Reconciling Cyclical Movements in the Marginal Value of Time and the Marginal Product of Labor," Journal of Political Economy, University of Chicago Press, vol. 117(2), pages 281-323, 04.
  17. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  18. Ehrmann, Michael & Fratzscher, Marcel, 2004. "Taking stock: monetary policy transmission to equity markets," Working Paper Series 0354, European Central Bank.
  19. Markus K. Brunnermeier & Stefan Nagel, 2006. "Do Wealth Fluctuations Generate Time-varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation," NBER Working Papers 12809, National Bureau of Economic Research, Inc.
  20. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  21. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
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