Asset pricing implications of a New Keynesian model

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 01 June 2007

Working Paper No. 326
By Bianca De Paoli, Alasdair Scott and Olaf Weeken

To match the stylised facts of goods and labour markets, the canonical New Keynesian model augments the optimising neoclassical growth model with nominal and real rigidities. We ask what the implications of this type of model are for asset prices. Using a second-order approximation, we examine bond and equity returns, the equity risk premium, and the behaviour of the real and nominal term structure. We catalogue the factors that are most important for determining the size of risk premia and the slope and level of the yield curve. In a world of technology shocks only, increasing the degree of real rigidities raises risk premia and increasing nominal rigidities reduces risk premia. In a world of monetary policy shocks only, both real and nominal rigidities raise risk premia. The results indicate that the implications of the New Keynesian model for average asset returns depend critically on the characterisation of shocks hitting the model economy.

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