Risk premia, asset price bubbles, and monetary policy

Robert Jarrow () and Sujan Lamichhane

Journal of Financial Stability, 2022, vol. 60, issue C

Abstract: We develop a dynamic general equilibrium asset pricing model with heterogeneous beliefs to study the effects of monetary policy on prices, risk premia, asset price bubbles, and financial stability. We propose a new framework for monetary policy with respect to bubbles. Because bubble risk premia arise from an interaction between disagreements among investors and dynamic trading constraints, under a non-accommodative monetary policy, liquidity adjusted risk and bubble risk premia increase. What matters for policy is the trading constrained fraction/mass of agents that disagree about fundamentals (i.e. optimists/pessimists). Accommodative policy can lead to a larger fraction of trading constrained agents that disagree, larger bubbles, and increased systemic risk. An implication of our results is that accommodative monetary policy in response to the Covid-19 crisis does not increase systemic risk due to asset price bubbles, as long as the policy keeps inflation under control.

Keywords: Monetary policy; Risk premia; Asset price bubbles; Heterogeneous beliefs/disagreements; Financial stability (search for similar items in EconPapers)
JEL-codes: E44 E52 E58 G12 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:60:y:2022:i:c:s157230892200033x

DOI: 10.1016/j.jfs.2022.101005

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