The Risk Channel of Unconventional Monetary Policy

Research output: Working paper

Abstract

This paper examines how unconventional monetary policy affects asset prices and macroeconomic conditions by reallocating risk in the economy. I consider an environment with two main ingredients: heterogeneity in risk tolerance and limited asset market participation. Risk-tolerant investors take leveraged positions, exposing the economy to balance sheet recessions. Limited asset market participation implies the balance sheet of the central bank is non-neutral. Unconventional monetary policy reduces the risk premium and endogenous volatility. During balance sheet recessions, asset purchases boost investment and growth. In contrast, during normal times, the expectation of future interventions reduces growth by its impact on savings. A commitment by the central bank to unwind its portfolio early, conditional on the recovery of leveraged institutions' balance sheet, reduces the risk premium by more than strategies involving holding its portfolio for longer. Asset purchases also have implications for the concentration of risk. Leveraged institutions respond to the policy by reducing risk-taking relatively more than risk-averse investors. As risk concentration falls, the probability of negative tail-events is reduced, enhancing financial stability.
Original languageEnglish (US)
Number of pages49
StatePublished - Aug 2016

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Balance sheet
Unconventional monetary policy
Assets
Recession
Investors
Risk premium
Purchase
Market participation
Central bank
Asset markets
Asset prices
Financial stability
Savings
Macroeconomic conditions
Risk-averse
Risk tolerance
Risk taking

Cite this

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abstract = "This paper examines how unconventional monetary policy affects asset prices and macroeconomic conditions by reallocating risk in the economy. I consider an environment with two main ingredients: heterogeneity in risk tolerance and limited asset market participation. Risk-tolerant investors take leveraged positions, exposing the economy to balance sheet recessions. Limited asset market participation implies the balance sheet of the central bank is non-neutral. Unconventional monetary policy reduces the risk premium and endogenous volatility. During balance sheet recessions, asset purchases boost investment and growth. In contrast, during normal times, the expectation of future interventions reduces growth by its impact on savings. A commitment by the central bank to unwind its portfolio early, conditional on the recovery of leveraged institutions' balance sheet, reduces the risk premium by more than strategies involving holding its portfolio for longer. Asset purchases also have implications for the concentration of risk. Leveraged institutions respond to the policy by reducing risk-taking relatively more than risk-averse investors. As risk concentration falls, the probability of negative tail-events is reduced, enhancing financial stability.",
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