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LFIN_DP_2022-08.pdf
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Abstract
We study the role of the cost of inflation channel in determining the risk premium in a (nonlinear) New Keynesian DSGE model. Relying on a Calvo (or Rotemberg) price setting, we show that while the cost of inflation channel generates the desired term premium moments, it suffers from nontrivial, counterintuitive approximation errors in the price dispersion function. In addition to documenting the issues, we propose ways to alleviate them, including a quasikinked demand function as a risk-generating mechanism.
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