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

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.