Monetary policy has pursued the concept of inflation targeting. This has been implemented in many countries. Here interest rates are supposed to respond to an inflation gap and output gap. Despite long term continuing growth of the world financial assets, recently, monetary policy, in particular in the U.S. after the subprime credit crisis, was challenged by severe disruptions and a meltdown of the financial market. Subsequently, academics have been in search of a type of monetary policy that does allow to influence in an appropriate manner the investor's behavior and, thus, the dynamics of the economy and its financial market. The paper suggests a dynamic portfolio approach. It allows one to study the interaction between investors` strategic behavior and monetary policy. The article derives rules that explain how monetary authorities should set the short term interest rate in interaction with inflation rate, economic growth, asset prices, risk aversion, asset price volatility, and consumption rates. Interesting is that the inflation rate needs to have a certain minimal level to allow the interest rate to be a viable control instrument. A particular target interest rate has been identified for the desirable optimal regime. If the proposed monetary policy rule is applied properly, then the consumption rate will remain stable and the inflation rate can be kept close to a minimal possible level. Empirical evidence is provided to support this view. Additionally, in the case of an economic crisis the proposed relationships indicate in which direction to act to bring the economy back on track.
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number
247.