Asset Pricing in the Production Economy Subject to Monetary Shocks
48 Pages Posted: 11 Jun 2009 Last revised: 24 Sep 2011
Date Written: January 14, 2011
This paper derives approximate analytical solutions for various financial assets in the production economy with monetary shocks. Both technology and monetary shocks drive the dynamics of various financial assets. Special cases of permanent and transitory shocks are considered.The solutions based on the loglinear approximation framework allow for a decomposition of risk that comes from real and monetary sides of the economy. Equity premium, volatility of the risk-free rate, Sharpe ratio, and inflation risk premium are calibrated to quarterly historical U.S. data. Because of non-separable preferences over consumption and real monetary holdings in the utility, the model produces a realistic Sharpe ratio for empirically reasonable values of the relative risk aversion parameter, but results in the low equity premium. However, the results suggest that qualitatively the real business cycle model with monetary shocks has an advantage over the real business cycle model with respect to matching the key asset pricing facts.
Keywords: real business cycle models, monetary shocks, equity premium, Sharpe ratio, inflation risk premium, volatility of the risk-free rate
JEL Classification: E32, E41, E43, E44, G12
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