Rare events and news in a rational expectations economy

Abstract

We examine the effect of inflation risk on a rational expectations monetary economy with endogenous production. The risk that we consider is of a change in the rate money growth from an initial steady-state level to a new level which is selected from a known distribution. The event of policy change is considered to be rare. The inclusion of rare events means that rational expectations does not require deviations of actual from expected inflation to be of zero mean or to be serially uncorrelated. We view the probability of a policy change, and the distribution of ensuing policy parameters as potentially changing over time. This highlights the role of News in determining the equilibrium of the economy. In the absence of any actual real or monetary shocks, changes in the perception about the likelihood and severity of a rare event have price, real and distributional effects. We find that inflation risk has price, real, and distributional effects.A risk of higher inflation increases the equilibrium price level and nominal interest rates. Inflation risk induces an increase in capital investment and production, and reduces the steady-state rate of return on equity. If the policy does not actually change, the ex-post real interest rate increases. The change in rates of return leads to a redistribution of wealth away from borrowers of nominal instruments towards lenders. Also we find that the theoretical second moment of future money growth has (almost) no effects on the economy.