Policy design in a model with swings in risk appetite

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

Cyclical Risk Aversion, Precautionary Saving and Monetary Policy

This paper analyzes the conduct of monetary policy in an environment in which cyclical swings in risk appetite affect households' propensity to save. It uses a New-Keynesian model featuring external habit formation to show that taking note of precautionary saving motives justifies an accommodative policy bias in the face of persistent, adverse disturbances. Equally, policy should be more restrictive - i.e. `lean against the wind' - following positive shocks. Since the size of these `risk-adjustments' is increasing in the degree of macroeconomic volatility, ignoring this channel could lead to larger policy errors in turbulent times - with good luck translating into good policy.precautionary saving, monetary policy, cyclical risk aversion, macro-finance, non-linearities

A sunspot-based theory of unconventional monetary policy

This paper is about the effectiveness of qualitative easing, a form of unconventional monetary policy that changes the risk composition of the central bank balance sheet. We construct a general equilibrium model where agents have rational expectations, and there is a complete set of financial securities, but where some agents are unable to participate in financial markets. We show that a change in the risk composition of the central bank’s balance sheet affects equilibrium asset prices and economic activity. We prove that, in our model, a policy in which the central bank stabilizes non-fundamental fluctuations in the stock market is self-financing and leads to a Pareto efficient outcome

What lies beneath? A time-varying FAVAR model for the UK transmission mechanism

This paper uses a time-varying Factor Augmented VAR to investigate the evolving transmission of monetary policy and demand shocks in the UK. Simultaneous estimation of time-varying impulse responses of a large set of macroeconomic variables and disaggregated prices suggest that the response of inflation, money supply and asset prices to monetary policy and demand shocks has changed over the sample period. In particular, during the post-1992 inflation targeting period, monetary policy shocks started having a bigger impact on prices, a smaller impact on activity and began contributing more to overall volatility. In contrast, demand shocks had the largest impact on these variables before the 1990s. We also document changes in the response of disaggregated prices, with the median reaction to contractionary policy shocks becoming more negative and the distribution more dispersed post-1992. JEL Classification: C38, E44, E52Factor Augmented VAR, monetary policy, sign restrictions, timevarying coefficients, transmission mechanism

The theory of unconventional monetary policy

This paper is about the effectiveness of qualitative easing, a form of unconventional monetary policy that changes the risk composition of the central bank balance sheet with the goal of stabilizing economic activity. We construct a general equilibrium model where agents have rational expectations and there is a complete set of financial securities, but where some agents are unable to participate in financial markets. We show that a change in the risk composition of the central bank’s balance sheet will change equilibrium asset prices and we prove that, in our model, a policy in which the central bank stabilizes non-fundamental fluctuations in the stock market is Pareto improving and self-financing

Essays on macro-finance.

This thesis is a collection of four essays dealing with issues on the verge of macroeconomics and finance. The first two chapters are joint with Bianca De Paoli. In the first one, we try to analyze factors causing risk premia to vary over time. The second one is an attempt to understand how these factors - manifesting themselves through swings in the desire to save for precautionary reasons - affect monetary policy. We show analytically that in endowment economies, procyclical recession expectations can 'outweigh' countercyclical changes in 'risk-aversion' - generating counterfactual risk-premium behavior. However, allowing shocks or habits to be sufficiently persistent, or explicitly accounting for the impact of habits on consumption, suffices to generate countercyclical recession risks and risk premia. We also show that taking note of precautionary saving motives justifies an accommodative policy bias in the face of persistent, adverse disturbances. Equally, policy should be more restrictive - i.e. 'lean against the wind' - following positive shocks. Both of these essays rely on approximate solutions to a simple, external habit model. In the third chapter, I derive closed form formulae for the model's solution. I then use these formulae to estimate the model and analyze its ability to jointly fit consumption growth and asset price data. I find no specification capable of simultaneously matching these data and argue that 'exotic' shock distributions are an unlikely panacea. In general, however, closed form formulae for asset prices cannot be derived analytically and need to be approximated. The final chapter proposes a method of doing exactly that. In contrast to several alternative approaches, the approximating function is not restricted to be a polynomial in state variables. This flexibility and efficient use of nested solutions can allow 'low-order' formulae to exceed the accuracy of higher-order perturbation approximations

What lies beneath? A time-varying FAVAR model for the UK transmission mechanism

This paper uses a time-varying Factor Augmented VAR to investigate the evolving transmission of monetary policy and demand shocks in the UK. Simultaneous estimation of time-varying impulse responses of a large set of macroeconomic variables and disaggregated prices suggest that the response of inflation, money supply and asset prices to monetary policy and demand shocks has changed over the sample period. In particular, during the post-1992 inflation targeting period, monetary policy shocks started having a bigger impact on prices, a smaller impact on activity and began contributing more to overall volatility. In contrast, demand shocks had the largest impact on these variables before the 1990s. We also document changes in the response of disaggregated prices, with the median reaction to contractionary policy shocks becoming more negative and the distribution more dispersed post-1992

The household fallacy

We refer to the idea that government must ‘tighten its belt’ as a necessary policy response to higher indebtedness as the household fallacy. We provide a reason to be skeptical of this claim that holds even if the economy always operates at full employment and all markets clear. Our argument rests on the fact that, in an overlapping-generations (OLG) model, changes in government debt cause changes in the real interest rate that redistribute the burden of repayment across generations. We do not rely on the assumption that the equilibrium is dynamically inefficient, and our argument holds in a version of the OLG model where the real interest rate is always positive

The business cycle implications of banks' maturity transformation

This paper develops a DSGE model where banks use short-term deposits to provide firms with long-term credit. The demand for long-term credit arises because firms borrow in order to finance their capital stock which they only adjust at infrequent intervals. Within an RBC framework, we show that maturity transformation in the banking sector dampens the consumption and investment response to a technology shock. Our model also implies that the average deposit rate is less persistent than the average long-term loan rate, which we show is in line with corporate interest rate data in the US

An efficient method of computing higher-order bond price perturbation approximations

This paper develops a fast method of computing arbitrary order perturbation approximations to bond prices in DSGE models. The procedure is implemented to third order where it can shorten the approximation process by more than 100 times. In a consumption-based endowment model with habits, it is further shown that a third-order perturbation solution is more accurate than the log-normal method and a procedure using consol bonds.Perturbation method; DSGE models; habit model; higher-order approximation.