On the Need for a New Approach to Analyzing Monetary Policy
University of California, Los Angeles (UCLA) - Department of Economics; National Bureau of Economic Research (NBER)
Patrick J. Kehoe
Federal Reserve Bank of Minneapolis - Research Department; University of Minnesota - Twin Cities - Department of Economics; National Bureau of Economic Research (NBER)
September 1, 2008
We present a pricing kernel that summarizes well the main features of the dynamics of interest rates and risk in postwar U.S. data and use it to uncover how the pricing kernel has moved with the short rate. Our findings imply that standard monetary models miss an essential link between the central bank instrument and the economic activity that monetary policy is intended to affect, and thus we call for a new approach to monetary policy analysis. We sketch a new approach using an economic model based on our pricing kernel. The model incorporates the key relationships between policy and risk movements in an unconventional way: the central bank's policy changes are viewed as primarily intended to compensate for exogenous business cycle fluctuations in risk that threaten to push inflation off target. This model, while an improvement over standard models, is considered just a starting point for their revision.
Keywords: Asset pricing kernel, Interest rate dynamics, Expected excess returns, Yield curve, Term structure, Taylor rule
JEL Classification: E52, E42, G12working papers series
Date posted: September 21, 2008
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