Risk Capacity and Optimal Monetary Policy

TL;DR

This paper develops a framework for optimal monetary policy considering endogenous risk premia driven by redistribution among risk-bearing agents, introducing the concept of Marginal Risk Capacity as a key determinant.

Contribution

It introduces Marginal Risk Capacity as a novel sufficient statistic linking risk premia to monetary policy, and analyzes its implications for policy design and macroprudential tools.

Findings

MRC governs the risk premium wedge affecting policy outcomes.

The presence of MRC leads to a risk capacity trap causing transmission collapse.

Optimal policy preemptively avoids the risk capacity trap.

Abstract

We characterize optimal monetary policy when policy endogenously moves risk premia through redistribution across agents who differ in their willingness to bear risk. The analytical core is Marginal Risk Capacity, the covariance of monetary policy exposures with marginal propensities to take risk. This sufficient statistic governs this channel as MPCs govern the consumption channel. MRC enters the Ramsey criterion as a risk premium wedge that breaks divine coincidence, vanishes if and only if macroprudential tools are available, and generates a new inflation bias under discretion. Solving the Ramsey problem globally reveals a risk capacity trap where transmission collapses, and optimal policy preemptively prevents it.