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

Abstract

In this study I examine the welfare implications of monetary policy by constructing a novel New Keynesian model that properly accounts for asset pricing facts. 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. Additionally, the second order approximation allows monetary policy to have positive welfare effects on the labor share of income. I show that this channel is generally absent in standard macroeconomic models that do not take risk into account. 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 stabilizing the medium to long term over the very short run.