Changes in Equity Risk Perceptions: Global Consequences and Policy Responses

The current weakness in the global economy has generated a debate on the likely outlook for the
world economy and the appropriate response for monetary policies. The world economy is currently
being buffeted by a number of major shocks. A particular feature has been the large fall in equity
markets in many countries. In this paper we use the MSG3 global economic model to assess the
impact on the global economy of a sharp rise in the equity risk premium in a number of countries.
In particular we examine whether a rise in equity risk premia (or fall in productivity which has
many similar implications) is a shock to aggregate supply or aggregate demand. We explore the
difference in the transmission mechanism if the shocks occur just in one country (i.e. the United
States) versus across the OECD generally. We then assess the appropriate responses of monetary
policy to shocks of this type and explore whether there are gains to coordinating the monetary
policy responses of the G7.