Welfare Effect of Interest Rate Volatility

This paper studies welfare effect of interest rate shocks, in particular, the relationship between volatility of interest rate shocks and ex-ante welfare of risk-averse households. It shows that a positive relationship holds for three widely used preference representations over a wide range of structural parameter values, in a 2-period model with fixed endowments. A critical dependence on the structure of endowments is shown, with smooth endowment flows and strong dependence of present endowed wealth on the interest rate supporting the positive relationship. The positive result extends to an infinite-period economy model with financial frictions, a model that has the ability of explaining some key business cycle moments and asset prices. Finally, we show policy implication of the identified welfare effect with simple policy  experiments.