A preliminary exploration on stochastic dynamic asset allocation models under a continuous-time sticky-price general equilibrium

Abstract

ABSTRACTThis article studies asset allocation problems under endogenous macroeconomic dynamics and monetary policy rules, by merging a continuous-time sticky-price general equilibrium model based on the New Keynesian framework with a stochastic dynamic portfolio selection model. Under optimal allocation strategies, the inverse of the Arrow–Pratt relative risk aversion function of investors decreases monotonically with a rising risk-free nominal interest rate, and exhibits a U shape with respect to inflation. This shows that, under the premise of an inflation-targeting monetary policy rule, the investors’ relative inclination for risky assets grows when inflation deviates from its steady state, in expectation for a countervailing nominal policy rate. The article also uses the model to discuss the macro-prudential problem of the feedback effects of the investors’ intertemporal utility-maximizing behaviour on the economy. Preliminary results show that the existence of risky assets in the economy can have an effect similar to that of the financial accelerator. This gives another possible explanation for the wedge effect beyond the traditional incentive theory.