This paper analyzes the conduct of monetary policy in an environment in which cyclical swings in risk appetite affect households' propensity to save. It uses a New-Keynesian model featuring external habit formation to show that taking note of precautionary saving motives justifies an accommodative policy bias in the face of persistent, adverse disturbances. Equally, policy should be more restrictive - i.e. `lean against the wind' - following positive shocks. Since the size of these `risk-adjustments' is increasing in the degree of macroeconomic volatility, ignoring this channel could lead to larger policy errors in turbulent times - with good luck translating into good policy.

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Bianca De Paoli and Pawel Zabczyk

2 March 2012     Paper Number CEPDP1132

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This CEP discussion paper is published under the centre's programme.