Welfare Implications of Asset Pricing Facts: Should Central Banks Fill Gaps or Remove Volatility?

Abstract

The welfare cost of economic uncertainty has a term structure that is a simple transformation of the term structures of the equity premium and interest rates. Twenty years of financial market data suggest a term structure of welfare costs that is downward-sloping on average, especially during downturns. This evidence offers guidance in selecting a model to study the benefits of macroeconomic stabilization from a structural perspective. A model with nominal rigidities and nonlinear external habits can rationalize the evidence, and it implies that the competitive volatility of consumption is inefficient. The model is observationally equivalent in its quantity implications to a standard New Keynesian model with CRRA utility but the optimal policy prescription is overturned. In the model the central bank should focus on removing consumption volatility (a targeting of risk premia) rather than on filling the gap between consumption and its flexible-price counterpart (inflation targeting).