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Monetary policy and asset prices with belief-driven fluctuations

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  • Airaudo, Marco
  • Cardani, Roberta
  • Lansing, Kevin J.

Abstract

We present a heterogeneous agents New-Keynesian model subject to a cost channel of monetary policy transmission. Constant turnover between long-time traders and newcomers in market activities, combined with restricted trading opportunities, introduces a feedback from the stock market to real activity, making stock prices non-redundant for the business cycle. We show that strict inflation targeting can lead to equilibrium indeterminacy, even if the policy rule satisfies the Taylor principle. A belief-driven shock to stock price generates relative volatilities of key financial variables which are very close to what is observed in U.S. data. This result hints to the possibility that the financial instability witnessed since the mid-to-late 1990s was the result of waves of (rational) exuberance and pessimism in financial markets. Our analysis suggests that a mild response to stock prices in the central bank's policy rule can restore equilibrium determinacy and therefore rule out non-fundamental volatility.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 37 (2013)
Issue (Month): 8 ()
Pages: 1453-1478

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Handle: RePEc:eee:dyncon:v:37:y:2013:i:8:p:1453-1478

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Web page: http://www.elsevier.com/locate/jedc

Related research

Keywords: Equilibrium determinacy; Asset prices; Cost channel; Monetary policy; Heterogeneous agents;

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References

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Cited by:
  1. Paolo Gelain & Kevin J. Lansing & Caterina Mendicino, 2012. "House prices, credit growth, and excess volatility: implications for monetary and macroprudential policy," Working Paper Series 2012-11, Federal Reserve Bank of San Francisco.
  2. Airaudo, Marco, 2013. "Monetary policy, stock prices, and consumption externalities," Economics Letters, Elsevier, vol. 120(3), pages 537-541.
  3. Marco Airaudo & Salvatore Nisticò & Luis-Felipe Zanna, 2014. "Learning, Monetary Policy and Asset Prices," Working Papers 4/14, Sapienza University of Rome, DISS.
  4. Muhammad Ali Nasir & Alaa M. Soliman, 2014. "Aspects of Macroeconomic Policy Combinations and Their Effects on Financial Markets," Economic Issues Journal Articles, Economic Issues, vol. 19(1), pages 95-118, March.

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