This paper incorporates limited asset markets participation in dynamic general equilibrium and develops a simple analytical framework for monetary policy analysis. Aggregate dynamics and stability properties of an otherwise standard business cycle model depend nonlinearly on the degree of asset market participation. While [`]moderate' participation rates strengthen the role of monetary policy, low enough participation causes an inversion of results dictated by conventional wisdom. The slope of the [`]IS' curve changes sign, the [`]Taylor principle' is inverted, optimal welfare-maximizing discretionary monetary policy requires a passive policy rule and the effects and propagation of shocks are changed. However, a targeting rule implementing optimal policy under commitment delivers equilibrium determinacy regardless of the degree of asset market participation. Our results may justify Fed's behavior during the [`]Great Inflation' period.
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Volume (Year): 140 (2008) Issue (Month): 1 (May) Pages: 162-196 Download reference. The following formats are available: HTML
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