Asset pricing in the production economy subject to monetary shocks

This paper derives approximate analytical solutions for various financial assets in the production economy with monetary shocks. Both technology and monetary shocks drive the dynamics of various financial assets. Special cases of permanent and transitory shocks are considered. The solutions based on the loglinear approximation framework allow for a decomposition of risk that comes from real and monetary sides of the economy. Equity premium, volatility of the risk-free rate, Sharpe ratio, and inflation risk premium are calibrated to quarterly historical U.S. data. The model produces a realistic Sharpe ratio and inflation risk premium for empirically reasonable values of the relative risk aversion parameter, but results in the low equity premium. Overall, the results suggest that qualitatively the real business cycle model with monetary shocks has an advantage over the real business cycle model with respect to matching the key asset pricing facts.

Research highlights► I derive approximate analytical solution of the RBC model with monetary shocks. ► Both technology and monetary shocks drive the dynamics of various financial assets. ► The solutions based on the log-linear approximation framework of Campbell (1994). ► Qualitatively the model has advantage w.r.t. matching the key asset pricing facts.