The Equity Premium, Long-Run Risks to R-Star, and Asymmetric Optimal Monetary Policy

68 Pages Posted: 13 Aug 2019

See all articles by Anthony M. Diercks

Anthony M. Diercks

Board of Governors of the Federal Reserve System: Monetary and Financial Market Analysis

Date Written: August 9, 2019

Abstract

With the Federal Reserve undergoing a serious review of its strategy, this paper provides a timely analysis that focuses on longer-run themes and monetary policy's potential influence. If we take the stance that asset prices indicate a high cost of exposure to long-run risks, this has very interesting implications for monetary policy that ripple through a surprisingly broad set of dimensions. There is an intuitive result that a Ramsey planner might wish to attenuate long-run risks (a key contributor to shifts in r-star). Less intuitively, I show that a Ramsey policymaker will induce a tolerance for skewness and a higher average inflation rate than is typically advocated in the literature. A variety of factors contribute to these results. First, deep non-linearities in the model entail that the policymaker behaves asymmetrically in its countercyclical policies. Second, the presence of capital generates longer-run effects (hysteresis) and additional tradeoffs, which implies that "countercyclical" in this model takes on a lower frequency theme. And third, imperfect competition leads to the pursuit of a higher average inflation rate to offset the related welfare costs.

Keywords: Asset Pricing, Long-Run Risk, R-Star, Monetary Policy

JEL Classification: E00, G00

Suggested Citation

Diercks, Anthony M., The Equity Premium, Long-Run Risks to R-Star, and Asymmetric Optimal Monetary Policy (August 9, 2019). Available at SSRN: https://ssrn.com/abstract=3435372 or http://dx.doi.org/10.2139/ssrn.3435372

Anthony M. Diercks (Contact Author)

Board of Governors of the Federal Reserve System: Monetary and Financial Market Analysis ( email )

20th and C Streets, NW
Washington, DC 20551
United States

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