Monetary Policy, Fear, and the Stock Market

I analyze a setting in which monetary policy has a state dependent effect due to an endogenously driven information channel. Specifically, I develop a model of investment in risky capital, where a central bank holds private information regarding the state of the economy and sets an interest rate accordingly in order to stabilize aggregate demand. Lowering the interest rate stimulates investment via the standard channel, but also signals weaker economic conditions, which reduces investors' confidence and their desire to invest. The information effect is negligible when the economy is strong, but can become significant when the economy is weaker. In a sufficiently weak economy, reducing the interest rate generates a decline in investment. Thus, a policy aimed at stimulating investment might unintentionally cause the opposite result, weakening aggregate demand even further. The reduction in aggregate demand is inefficient, as it reflects a coordination failure among investors. In line with the model's s prediction, I provide empirical evidence suggesting that the information effect of monetary policy is stronger in times of weaker economic conditions.