Working Paper: NBER ID: w16386
Authors: Pierpaolo Benigno; Luigi Paciello
Abstract: Asset prices and the equity premium might reflect doubts and pessimism. Introducing these features in an otherwise standard New-Keynesian model changes in a quite substantial way the nature of the policy that maximizes the welfare of the consumers in the model. First, following productivity shocks, optimal policy in this model is more accommodating than in a standard New-Keynesian model, and may even inflate the equity premium. Second, asset-price movements improve the inflation-output trade-off so that average output can rise without increasing much average inflation. Finally, a strict inflation-targeting policy may result in lower average welfare than a more flexible inflation-targeting policy, which instead increases the comovements between inflation, asset prices and output growth.
Keywords: monetary policy; asset prices; equity premium; New Keynesian model; ambiguity aversion
JEL Codes: E31; E32; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Doubts (D80) | More accommodative monetary policy (E52) |
| Productivity shocks (O49) | More accommodative monetary policy (E52) |
| Asset price movements (G19) | Inflation-output tradeoff (E31) |
| More flexible monetary policy (E52) | Increased average output (E23) |
| Strict inflation targeting (E31) | Lower average welfare (I39) |