Abstract: With the Federal Reserve undergoing a serious review of its strategy, this paper provides a timely analysis that focuses on longer-run themes and monetary policy's potential influence. If we take the stance that asset prices indicate a high cost of exposure to long-run risks, this has very interesting implications for monetary policy that ripple through a surprisingly broad set of dimensions. There is an intuitive result that a Ramsey planner might wish to attenuate long-run risks (a key contributor to shifts in r-star). Less intuitively, I show that a Ramsey policymaker will induce a tolerance for skewness and a higher average inflation rate than is typically advocated in the literature. A variety of factors contribute to these results. First, deep non-linearities in the model entail that the policymaker behaves asymmetrically in its countercyclical policies. Second, the presence of capital generates longer-run effects (hysteresis) and additional tradeoffs, which implies that ``countercyclical" in this model takes on a lower frequency theme. And third, imperfect competition leads to the pursuit of a higher average inflation rate to offset the related welfare costs.
The analysis and conclusions set forth in this paper are those of the author and do not indicate concurrence by other members of the research staff or the Board of Governors of the Federal Reserve System.