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Cyclical Risk Aversion, Precautionary Saving, and Monetary Policy

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  • The views expressed here do not necessarily represent those of the Bank of England or the Federal Reserve System. For helpful comments and suggestions, we would like to thank seminar and conference participants at the Bank of England, European Central Bank, Norges Bank, London School of Economics, 2007 Chief Economists’ Workshop, 2008 MMF conference, 4th Dynare conference. All remaining errors are ours.

Abstract

This paper analyzes the conduct of monetary policy in an environment in which cyclical swings in risk appetite affect households’ propensity to save. It uses a New Keynesian model featuring external habit formation to show that taking note of precautionary saving motives justifies an accommodative policy bias in the face of persistent, adverse disturbances. Equally, policy should be more restrictive—that is “lean against the wind”—following positive shocks. Under sufficiently persistent habits it is, in fact, optimal to increase interest rates following a rise in productivity.

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