2026 General Seminar - James F. Hansen

The Equity Premium, Long-run Risk, and Asymmetric Optimal Monetary Policy

Abstract: We show that optimal monetary policy is asymmetric: monetary policy should respond more to negative shocks than positive shocks (especially shocks that lower r-Star). If asset prices imply high exposure to long-run risk, this has surprising implications for monetary policy that ripple through a broad set of dimensions. There is an intuitive result that a Ramsey planner might wish to attenuate long-run risk. Less intuitively, we show that a Ramsey planner will induce a tolerance for skewness and a higher average inflation rate. A variety of factors contribute to these results. First, deep non-linearities in the model imply that the policymaker behaves asymmetrically in implementing countercyclical policy. Second, the presence of capital gives scope to provide insurance against future shocks. Third, imperfect competition leads to the pursuit of higher average inflation to offset related welfare costs. We show that these results hold analytically and quantitatively in an economy that matches standard asset-pricing and macro facts.