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Title: Monetary Policy, Velocity, and the Equity Premium

Author(s): Christopher Gust and J David L�pez-Salido

Publication Date: August 2009

Keyword(s): equity premium, monetary policy and velocity

Programme Area(s): International Macroeconomics

Abstract: 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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Bibliographic Reference

Gust, C and L�pez-Salido, J. 2009. 'Monetary Policy, Velocity, and the Equity Premium'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=7388