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Monetary Policy, Stock Price Misalignments and Macroeconomic Instability

  • Bask, Mikael

    ()

    (Hanken School of Economics)

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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File URL: http://dhanken.shh.fi/dspace/bitstream/10227/369/1/540-978-952-232-036-0.pdf
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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
Date of revision:
Handle: RePEc:hhb:hanken:0540
Contact details of provider: 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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  4. Menkhoff, Lukas & Taylor, Mark P., 2006. "The Obstinate Passion of Foreign Exchange Professionals: Technical Analysis," Hannover Economic Papers (HEP) dp-352, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
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  11. Alexandros Kontonikas & Alberto Montagnoli, 2005. "Optimal Monetary Policy and Asset Price Misalignments," Working Papers 2005_9, Business School - Economics, University of Glasgow.
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  14. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
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  17. Mikael Bask & Carina Selander, 2009. "Robust Taylor rules under heterogeneity in currency trade," International Economics and Economic Policy, Springer, vol. 6(3), pages 283-313, October.
  18. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
  19. Pastor, Lubos & Veronesi, Pietro, 2006. "Was there a Nasdaq bubble in the late 1990s?," Journal of Financial Economics, Elsevier, vol. 81(1), pages 61-100, July.
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  24. Goodhart, Charles & Hofmann, Boris, 2000. "Financial Variables and the Conduct of Monetary Policy," Working Paper Series 112, Sveriges Riksbank (Central Bank of Sweden).
  25. McCallum, Bennett T., 2007. "E-stability vis-a-vis determinacy results for a broad class of linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 31(4), pages 1376-1391, April.
  26. James B. Bullard & Eric Schaling, 2002. "Why the Fed should ignore the stock market," Review, Federal Reserve Bank of St. Louis, issue Mar., pages 35-42.
  27. Kaushik Mitra & James Bullard, 2004. "Determinacy, Learnability, and Monetary Policy Inertia," Royal Holloway, University of London: Discussion Papers in Economics 04/14, Department of Economics, Royal Holloway University of London, revised Jul 2004.
  28. Glenn D. Rudebusch, 2005. "Monetary policy and asset price bubbles," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue aug5.
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