Abstract
The paper uses a Walrasian two-period financial market model with informed and uninformed constant absolute risk averse (CARA) rational investors and noise traders. The investors allocate their initial wealth between risky assets and risk-free fiat money. The analysis concentrates on the effects of decreasing value of money, or inflation, on the rational investors’ behavior and the asset market. The main findings are the following: Inflation does not affect the informed investors’ prediction coefficient but makes that of the uninformed investors diminish. Inflation does not affect rational investors’ risk but makes the asset price more sensitive to fundament-based and sentiment-based shocks. Inflation changes the market price of the risky asset rise; while it has no effects on the informed investors’ demand of the risky asset, it does affect the uninformed investors’ demand. Finally, inflation makes the asset market more volatile.
Highlights
Zero or negative real interest rates have recently been common in many countries, including the USA, Japan, Switzerland, Norway, Sweden and the Eurozone. Caballero and Farhi (2018) discuss the issue and call it the “safety trap”
It causes a shortage in safe assets and reduces the wealth of risk averse investors, who tend to allocate a part of their investments in riskless assets
While the phenomenon of zero or negative real interest rates is mainly a monetary policy issue, it is clearly relevant to private savers and investors, who make long-term decisions about wealth accumulation and consider risk in their investments
Summary
Zero or negative real interest rates have recently been common in many countries, including the USA, Japan, Switzerland, Norway, Sweden and the Eurozone. Caballero and Farhi (2018) discuss the issue and call it the “safety trap”. The authors warn that the effect can be persistent and similar to the secular stagnation hypothesis (see Hansen 1939; Summers 2014) They suggest that the investors’ risk premium should be lowered by policy and claim that the early quantitative easing in the US subprime crisis and the outright monetary transactions in the Eurozone in late 2012 were apt examples of fight against the safety trap. While the phenomenon of zero or negative real interest rates is mainly a monetary policy issue, it is clearly relevant to private savers and investors, who make long-term decisions about wealth accumulation and consider risk in their investments In common sense, this means decisions of holding either risk-free or risky assets.
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