A Model of Monetary Policy and Risk Premia

Itamar Drechsler, Alexi Savov, Philipp Schnabl

NBER Working Paper No. 20141
Issued in May 2014
NBER Program(s):   AP   ME

We develop a dynamic asset pricing model in which monetary policy affects the risk premium component of the cost of capital. Risk-tolerant agents (banks) borrow from risk-averse agents (i.e. take deposits) to fund levered investments. Leverage exposes banks to funding risk, which they insure by holding liquidity buffers. By changing the nominal rate the central bank influences the liquidity premium in financial markets, and hence the cost of taking leverage. Lower nominal rates make liquidity cheaper and raise leverage, resulting in lower risk premia and higher asset prices, volatility, investment, and growth. We analyze forward guidance, a "Greenspan put", and the yield curve.

This paper was revised on August 7, 2015

Acknowledgments

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Document Object Identifier (DOI): 10.3386/w20141

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