Speaker : Dr. Vipul Mathur (IIM Bangalore)

Abstract:
Whether and how the monetary policy should respond to financial sector shocks has been an important inquiry in monetary economics in the recent times. A tremendous amount of interesting research has been conducted on this question, however, the policy prescription remains inconclusive. While the inter-linkages between central banking and financial markets have been explored through a variety of abstractions and frictions, the research has mostly focused on the role of nominal rigidities arising in the goods market as a channel for monetary policy transmission. An alternate channel for monetary policy is through asset market friction, in particular, the role of limited asset market participation. We develop a dynamic general equilibrium model in an environment where financial market participation is not only limited but also endogenously determined. In such a framework, monetary policy affects the economy through its effect on financial risk sharing. Crucially, monetary policy alters financial risk sharing by impacting both the consumption of the asset market participants (intensive margin) and the number of active market participants (extensive margin). In such a milieu, we first show that the optimal policy calls for a countercyclical response to a financial shock, in contrast to an inflation targeting policy which is pro-cyclical. Further, we analytically derive the equity premium and show that it is countercyclical to monetary policy. In particular, we show that show that optimal monetary policy, by being counter cyclical results in less risk sharing and a higher equity premium than an inflation targeting policy.