Working Paper: CEPR ID: DP7727
Authors: Christopher Gust; J. David López-Salido
Abstract: We use a DSGE model that generates endogenous movements in risk premia to examine the positive and normative implications of alternative monetary policy rules. As emphasized by the microfinance literature, variation in risk arises because households face fixed costs of transferring cash across financial accounts, implying that some households rebalance their portfolios infrequently. We show that the model can account for the mean returns on equity and the risk-free rate, and in line with empirical evidence generates a decline in the equity premium following an unanticipated easing of monetary policy. An important result that emerges from our analysis is that countercyclical monetary policy generates higher average welfare than constant money growth or zero inflation policies.
Keywords: countercyclical; equity premium; monetary policy; portfolio inertia; segmented markets
JEL Codes: E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Countercyclical monetary policy (E52) | higher average welfare (I30) |
| Countercyclical monetary policy (E52) | equity premium (G12) |
| Monetary policy shocks (E39) | equity premium (G12) |
| Systematic changes in monetary policy (E52) | household incentives to rebalance portfolios (D14) |
| household incentives to rebalance portfolios (D14) | asset prices and risk levels (G19) |