Publication Title

Macroeconomic Dynamics

Document Type

Article

Department or Program

Economics

Publication Date

7-1-2019

Keywords

Bounded Rationality, Heterogeneous Beliefs, Optimal Monetary Policy, Risk Management

Abstract

We assume that firms are more risk averse than households and that they manage their risk through a financial sector, which consists of learning and hedging. Firms that learn (by observing demand shocks) face less uncertainty and produce more than firms that hedge (by selling future production at a fixed price). If a policy or parameter change stabilizes the economy, then there is less learning and usually less production. Welfare, however, is usually maximized when the financial sector, which requires inputs but does not directly provide utility or affect production, is smallest. Monetary policy can improve welfare by either taxing learning or subsidizing hedging. If firms are risk averse over nominal profits instead of real profits, then interest rate policy can also improve welfare by stabilizing prices and thus minimizing the size of the financial sector.

Required Publisher's Statement

This article has been published in a revised form in Macroeconomic Dynamics https://doi.org/10.1017/S1365100517000578. This version is free to view and download for private research and study only. Not for re-distribution or re-use. © copyright holder.

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