Nominal Frictions, Monetary Policy, and Long-Run Risk
74 Pages Posted: 15 Oct 2012 Last revised: 26 Oct 2012
Date Written: October 15, 2012
I show that long-run risk - highly persistent variation in expected consumption growth - arises endogenously in a production economy with nominal frictions. The `long-run' part comes from price stickiness. Nominal frictions in the model generate a consumption growth process that shows low persistence unconditionally, but has a highly persistent conditional mean. The `risk' part comes from Epstein-Zin preferences, which result in a large risk premium being associated with variation in the conditional mean. The model provides new testable implications for long-run-risk models, and restricts the joint distribution of consumption and nominal equity and bond risk premia. A calibrated version of the model generates consumption, a risk-free interest rate, and equity risk premium behavior that are consistent with U.S. data.
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