Working Paper: CEPR ID: DP7388
Authors: Christopher Gust; J. David López-Salido
Abstract: We develop a DSGE model in which monetary policy generates endogenous movements in risk. The key feature of our model is that households rebalance their financial portfolio allocations infrequently, as they face a fixed cost of transferring cash across accounts. We show that the model can account for the mean returns on equity and the risk-free rate,and generates countercyclical movements in the equity premium that help explain the response of stock prices to monetary shocks. While stimulative monetary policy can lower risk in equity markets, it is also associated with higher inflation expectations and inflation risk premia. The model gives rise to periods in which the zero lower bound constraint on the nominal interest rate binds and demand for liquidity jumps, leading to procyclical movements in velocity.
Keywords: equity premium; monetary policy; velocity
JEL Codes: E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stimulatory monetary policy (E52) | equity premium (G12) |
| easing of monetary policy (E52) | equity premium (G12) |
| easing of monetary policy (E52) | households rebalancing portfolios (D14) |
| monetary policy shocks (E39) | equity premium (G12) |
| monetary policy (E52) | inflation expectations (E31) |
| inflation expectations (E31) | inflation risk premia (E31) |
| zero lower bound on nominal interest rates (E43) | demand for liquidity (E41) |
| increased demand for liquidity (E41) | equity premium (G12) |