Welfare Implications of the Term Structure of Returns: Should Central Banks Fill Gaps or Remove Volatility?

Pierlauro Lopez

No 742, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: The welfare cost of economic uncertainty has a term structure that is a simple transformation of the term structures of the equity premium and interest rates. Twenty years of financial market data suggest a term structure of welfare costs that is downward-sloping on average and during downturns. This evidence offers guidance in selecting a model to study the benefits of greater consumption stability from a structural perspective. A model with nominal rigidities and nonlinear external habits can rationalize the evidence and motivates the competitive level and volatility of consumption as inefficient. The model is observationally equivalent to a standard New Keynesian model with CRRA utility but the optimal policy prescription is overturned; in the model the central bank should focus on removing consumption volatility rather than on filling the gap between consumption and its flexible-price counterpart.

Date: 2016
New Economics Papers: this item is included in nep-dge, nep-mac, nep-mon, nep-sog and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed016:742

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