Monetary policy implications for risk premia of the extensive margin channel

This study examines how monetary policy impacts the conditional variation of the equity risk premia through firm entry and exit dynamics. A model incorporating variety growth fluctuations assesses asset pricing dynamics after a monetary policy shock. The framework features an endogenous mechanism for firm entry and exit, along with nominal rigidities in prices and wages. Empirical evidence from a Bayesian VAR (BVAR) analysis is presented to validate the equity premium’s response to conventional expansionary monetary policy shocks. The monetary policy shock is identified through a procedure that combines sign restrictions with high-frequency instruments. The findings suggest that wage rigidity and firm dynamics are critical mechanisms through which monetary policy affects asset prices. While price rigidities alone have a limited impact, wage rigidities, whether isolated or combined with price rigidities, lead to substantial changes in the equity premium.