Nominal Frictions, Monetrary Policy, and Long-Run Risk

Abstract

I show that long-run risk | highly persistent variation in expected consumption growth | arises endogenously in a production economy with nominal frictions. The ‘long-run’ part comes from price stickiness. Nominal frictions in the model generate a consumption growth process that shows low persistence unconditionally, but has a highly persistent conditional mean. The ‘risk’ part comes from Epstein-Zin preferences, which result in a large risk premium being associated with variation in the conditional mean. The model provides new testable implications for long-run-risk models, and restricts the joint distribution of consumption and nominal equity and bond risk premia. A calibrated version of the model generates consumption, a risk-free interest rate, and equity risk premium behavior that are consistent with U.S. data.