Working Papers, Hanken School of Economics
No 540:
Monetary Policy, Stock Price Misalignments and Macroeconomic Instability
Mikael Bask ()
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.
Keywords: Bubble Policy; Fundamental Analysis; Interest Rate Rule; Least Squares Learning; Macroeconomic Stability; Stock Price Bubble; Taylor Rule; Technical Analysis; (follow links to similar papers)
27 pages, June 5, 2009
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