DP7727 Monetary Policy and the Cyclicality of Risk
|Author(s):||Christopher Gust, J David López-Salido|
|Publication Date:||March 2010|
|Keyword(s):||countercyclical equity premium, monetary policy, portfolio inertia, segmented markets|
|Programme Areas:||International Macroeconomics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=7727|
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.