“Optimal Monetary Policy under Recursive Preferences and the Term Structure of Equity and Bond Risk Premia”
by Atanu Kumar Paul
Carneige Mellon University, Ph.D. Finance
I build a New Keynesian asset pricing model with optimal monetary policy and Epstein-Zin preferences that accounts for some of the stylized facts concerning the term structures of equity and bond risk premia. The model-implied term structure of equity risk premia and its volatility are downward sloping, the term structure of bond risk premia is upward sloping, and the term structure of Sharpe ratios on dividend strips is downward sloping. Under Epstein-Zin preferences, the central bank amplifies short- and long-run productivity shocks to maximize surprise utility in an optimal monetary policy setting by making the output gap procyclical with respect to these shocks. The output gap gradually falls after a positive short- or long-run productivity shock so short-horizon output and dividends are more procyclical than medium-horizon output and dividends. Under the optimal monetary policy, the weight on the difference between inflation and its target in the loss function is large so inflation closely tracks the inflation target, which is persistent and responds negatively to long-run productivity shocks. This makes long-horizon price levels more countercyclical than short-horizon price levels with respect to the long-run productivity shock.