A Model of Monetary Policy and Risk Premia
63 Pages Posted: 7 Nov 2013 Last revised: 5 Jan 2017
Date Written: July 28, 2015
We develop a dynamic asset pricing model in which monetary policy affects the risk premium component of the cost of capital. Risk-tolerant agents (banks) borrow from risk-averse agents (i.e. take deposits) to fund levered investments. Leverage exposes banks to funding risk, which they insure by holding liquidity buffers. By changing the nominal rate the central bank influences the liquidity premium in financial markets, and hence the cost of taking leverage. Lower nominal rates make liquidity cheaper and raise leverage, resulting in lower risk premia and higher asset prices, volatility, investment, and growth. We analyze forward guidance, a "Greenspan put'', and the yield curve.
Keywords: Monetary policy, leverage, risk premia, reaching for yield
JEL Classification: E52, E58, G12, G21
Suggested Citation: Suggested Citation