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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Monetary Policy and the Cyclicality of Risk
Christopher Gust and David López-Salido
2010-999  (June 2010)

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.

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Limited financial market participation, equity premium, inflation targeting

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