Monetary policy and the cyclicality of risk

By Christopher Gust and David Lopez-Salido

http://d.repec.org/n?u=RePEc:fip:fedgif:999&r=dge

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.

This paper matches the risk free rate and the equity premium, and shows how monetary policy can have an impact on both. It relies on the fact that there is limited participation, where households that are active on financial markets have a consumption that is much more volatile than for other households. Is this the solution to long standing puzzles?