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CEP discussion paper
Policy Design in a Model with Swings in Risk Appetite
Bianca De Paoli and Pawel Zabczyk
October 2012
Paper No' CEPDP1170:
Full Paper (pdf)

JEL Classification: E32; G12

Tags: policy design; cyclical risk aversion; new keynesian model; habit formation

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.