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Monetary Policy, Stock Price Misalignments and Macroeconomic Instability

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Author Info
Bask, Mikael () (Hanken School of Economics)

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Abstract

We augment the standard New Keynesian model for monetary policy design with stock prices in the economy and stock traders wh use a mix of fundamental and technical analyses. The central question in this paper is whether macroeconomic stability can be achieved by an appropriate policy by the central ank? In contrast with most of previous literature, we argue that the central bank should augment the interest rate rule with a term for stock price misalignments since a determiate and stable rational expectations equilibrium in the economy is then easier to achieve. This equilibrium is stable under least squares learning as well. Another interesting finding is that inertia in monetary policy does not promote macroeconomic stability when technical analysis plays a major role in stock trading. Even worse, if the central bank in its policy only indirectly responds to stock price misalignments via its effect on the inflation rate, a combination of strong inertia in monetary policy and a significant role for technical analysis in stock trading will lead to macroeconomic instability.

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Paper provided by Hanken School of Economics in its series Working Papers with number 540.

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Length: 27 pages
Date of creation: 05 Jun 2009
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Handle: RePEc:hhb:hanken:0540

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Postal: Hanken School of Economics, Arkadiankatu 22, P.O.B. 479; FIN 00101 Helsinki, Finland
Phone: +358-9-431 331
Fax: +358-9-431 33 333
Web page: http://www.hanken.fi
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Related research
Keywords: Bubble Policy; Fundamental Analysis; Interest Rate Rule; Least Squares Learning; Macroeconomic Stability; Stock Price Bubble; Taylor Rule; Technical Analysis;

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