Monetary Policy Rules and the Equity Premium in a Segmented Markets Model

Abstract

We study the effect of different monetary policy rules on stock and bond risk using a segmented financial market model. The optimal monetary policy rule in our model is risk-sharing and countercyclical after shocks in the financial markets. Under that policy, equity is not risky, and its return is low. The optimal policy, however, implies inflation risk and thus high return for nominal bonds. On the other hand, under inflation targeting, there is no insurance against financial income risk and the equity return is high. At the same time, inflation targeting insures against inflation, resulting in nominal bonds becoming attractive assets. Our model suggests that monetary policy objectives play a key role in affecting risk sharing, asset returns, and the equity premium.

Keywords: Risk-sharing, Segmented financial markets, Asset prices

JEL Classification: E44, E52, G12