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Learning, Monetary Policy and Asset Prices

  • Airaudo, Marco


    (Department of Economics & International Business, LeBow College of Business, Drexel University)

  • Nisticò, Salvatore


    (Universit‡ degli Studi di Roma "La Sapienza" and LUISS Guido Carli)

  • Zanna, Luis-Felipe


    (Research Department, International Monetary Fund)

We assess the conditions under which an interest rate rule granting an explicit response to stock prices can shield the economy against endogenous aggregate instability in the form of fluctuations driven by self-fulfilling beliefs, and fundamental equilibria that are not learnable in the Expectational Stability sense of Evans and Honkapohja (2001). To do so, we use a New-Keynesian DSGE model populated by Blanchard-Yaari non-Ricardian households. The constant turnover between long-time traders (holding assets) and newcomers (entering the market with no wealth at all) implies that the wedge between current and expected future aggregate consumption is affected by the market value of financial wealth, making stock prices non-redundant for the business cycle. We find that such policy is prone to generate non-fundamental fluctuations or fundamental fluctuations that are not learnable, unless both the turnover rate in markets and average profitability from investing in risky equity are significantly large. However, this appears to be the exception for most reasonable model calibrations, implying that, absent additional frictions, a systematic response to stock prices by monetary policy remains a bad idea in the New-Keynesian paradigm.

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Paper provided by LeBow College of Business, Drexel University in its series School of Economics Working Paper Series with number 2012-12.

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Length: 40 pages
Date of creation: 08 Feb 2012
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Handle: RePEc:ris:drxlwp:2012_012
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