Policy Design in a Model with Swings in Risk Appetite

Bianca De Paoli () and Pawel Zabczyk

CEP Discussion Papers from Centre for Economic Performance, LSE

Abstract: This paper studies the policy implications of habits and cyclical changes in agents' appetite for risk-taking. To do so, it analyses the non-linear solution of a New Keynesian (NK) model, in which slow-moving habits help match the cyclical properties of risk-premia. Our findings suggest that the presence of habits and swings in risk appetite can materially affect policy prescriptions. As in Ljungqvist and Uhlig (2000), a counter-cyclical fiscal instrument can eliminate habit-related externalities. Alternatively, monetary policy can partially curb the associated overconsumption by responding to risk premia. Specifically, periods in which risk premia are elevated (compressed) merit a looser (tighter) policy stance. However, the associated welfare gains appear quantitatively small.

Keywords: Policy design; cyclical risk aversion; New Keynesian model; habit formation (search for similar items in EconPapers)
JEL-codes: E32 G12 (search for similar items in EconPapers)
Date: 2012-10
New Economics Papers: this item is included in nep-mac and nep-upt
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https://cep.lse.ac.uk/pubs/download/dp1170.pdf (application/pdf)

Related works:
Journal Article: Policy design in a model with swings in risk appetite (2013)
Working Paper: Policy design in a model with swings in risk appetite (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:cep:cepdps:dp1170

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