The Equity Premium, Long-Run Risk, and Optimal Monetary Policy

Anthony Diercks
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Anthony Diercks: Federal Reserve Board

No 207, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: In this study I examine the welfare implications of monetary policy by constructing a novel production-based asset pricing New Keynesian model. I find that the Ramsey optimal monetary policy yields an inflation rate above 3.5% and inflation volatility close to 1.5%. The same model calibrated to a counterfactually low equity premium implies an optimal inflation rate close to zero and inflation volatility less than 10 basis points, consistent with much of the existing literature. Relatively higher optimal inflation is due to the greater welfare costs of recessions associated with matching the equity premium. The standard optimal policy that focuses on stabilizing inflation tends to amplify long-run risk. Furthermore, the interest rate rule that comes closest to matching the dynamics of the optimal Ramsey policy puts a sizable weight on capital growth along with the price of capital, as it emphasizes reducing long-run risk.

Date: 2016
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed016:207

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