Model Misspecification, the Equilibrium Natural Interest Rate, and the Equity Premium

Authors


  • I wish to thank Neil Rankin and Frank Smets for useful discussions and Sandrine Corvoisier for excellent research assistance. I also thank an anonymous referee and seminar participants at the EEA 2003 Meetings and at IGIER for useful comments and suggestions. The opinions expressed are personal and should not be attributed to the European Central Bank.

Abstract

This paper analyzes the natural rate of interest and the equity premium in a nonlinear model where agents are uncertain over both future technology growth and the future course of monetary policy. I show that model uncertainty, and notably uncertainty on the future course of monetary policy, can give rise to a sizable precautionary savings motive. This result is potentially problematic for both the estimation of the natural rate and its use as a policy indicator. Monetary uncertainty can also contribute to amplify the equity premium, and to account for its apparent, positive link with inflation.

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