Essays on macroeconomics and risk premium

Abstract

The thesis consists of three essays on how macroeconomic policy can be an important determinant of risk premium and how variations in risk premium may affect macroeconomic policy. Unconventional monetary policy represents a main example of how the transmission of macroeconomic policy is mediated by movements in risk premium. In the first essay, I examine how unconventional monetary policy affects asset prices by reallocating risk in the economy. I consider an environment with heterogeneity in risk tolerance and limited asset market participation. Risk-tolerant investors take leveraged positions, exposing the economy to balance sheet recessions. Limited asset market participation implies the balance sheet of the central bank is non-neutral. Unconventional monetary policy reduces the risk premium and endogenous volatility. During balance sheet recessions, asset purchases boost investment and growth. In contrast, during normal times, the expectation of future interventions reduces growth. Leveraged institutions respond to the policy by reducing risk-taking relatively more than risk-averse investors. As risk concentration falls, the probability of negative tail-events is reduced, enhancing financial stability. An important determinant of entrepreneurial activity in developing countries is the amount of risk the entrepreneur must bear. The second essay, joint with Robert M. Townsend, analyzes the risk-taking behavior of entrepreneurs. Using data from a survey conducted in villages in Thailand, we document substantial heterogeneity in entrepreneurial activity. The fraction of net worth invested by entrepreneurs in risky activities decreases over the life cycle. Consumption-to-wealth ratio is U-shaped, being high for young and old entrepreneurs. We propose a model that captures both the life cycle patterns and limited idiosyncratic insurance observed in the Thai data. An expansion in idiosyncratic insurance will reduce the idiosyncratic risk premium, increasing the proportion of wealth invested in risky activities and aggregate output. However, as the return on the project falls, entrepreneurs accumulate less wealth, reducing their welfare in the long-run. The third essay studies the optimal response of fiscal policy to a risk premium shock when a country is in a currency union. In the context of an open economy New Keynesian model, I show that the government should not deviate from the optimal provision of public goods at an attempt to stabilize the economy. A consumption tax is used to lean against the wind and reduce the real interest rate in the presence of a positive risk premium shock. A VAT tax allows the government to independently influence the terms of trade. Optimal fiscal policy has the property of being revenue-generating. Therefore, there is not necessarily a trade off between stabilization policy and fiscal consolidation.