Welfare effect of interest rate shocks and policy implications

Richard E. Ericson and Xuan Liu

Applied Financial Economics, 2012, vol. 22, issue 22, 1899-1917

Abstract: This article studies the welfare effect of exogenous country spread shocks and policy implications. First, country spread shocks are welfare-improving, a finding holding for three widely used preference representations over a wide range of structural parameter values, both in a two-period model with fixed endowments and in a workhorse Dynamic Stochastic General Equilibrium (DSGE) model of a small open economy. Second, it is always optimal to have procyclical policy unless (i) financial frictions are strong, (ii) policy responds to country spread gaps, and (iii) the subjective discount factor is endogenous.

Date: 2012
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DOI: 10.1080/09603107.2012.688939

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