Monetary Policy and the Cyclicality of Risk

31 Pages Posted: 17 Mar 2010

See all articles by Christopher J. Gust

Christopher J. Gust

Federal Reserve Board - Trade and Financial Studies

David Lopez-Salido

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: March 2010

Abstract

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.

Keywords: countercyclical equity premium, monetary policy, portfolio inertia, segmented markets

JEL Classification: E44, E52

Suggested Citation

Gust, Christopher J. and Lopez-Salido, David, Monetary Policy and the Cyclicality of Risk (March 2010). CEPR Discussion Paper No. DP7727. Available at SSRN: https://ssrn.com/abstract=1573431

Christopher J. Gust (Contact Author)

Federal Reserve Board - Trade and Financial Studies ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States

David Lopez-Salido

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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