Cataloged from PDF version of article.We examine the effect of inflation risk on a rational expectations monetary
economy with endogenous production. The risk that we consider is of a change in
the rate money growth from an initial steady-state level to a new level which is
selected from a known distribution. The event of policy change is considered to be
rare. The inclusion of rare events means that rational expectations does not require
deviations of actual from expected inflation to be of zero mean or to be serially
uncorrelated. We view the probability of a policy change, and the distribution of
ensuing policy parameters as potentially changing over time. This highlights the
role of News in determining the equilibrium of the economy. In the absence of any
actual real or monetary shocks, changes in the perception about the likelihood and
severity of a rare event have price, real and distributional effects.
We find that inflation risk has price, real, and distributional effects.A risk of
higher inflation increases the equilibrium price level and nominal interest rates.
Inflation risk induces an increase in capital investment and production, and reduces the steady-state rate of return on equity. If the policy does not actually change, the
ex-post real interest rate increases. The change in rates of return leads to a
redistribution of wealth away from borrowers of nominal instruments towards
lenders. Also we find that the theoretical second moment of future money growth
has (almost) no effects on the economy.Köseoğlu, ElifM.S
