Financial Market Segmentation, Stock Market Volatility and the Role of Monetary Policy

Abstract

We explore the role of monetary policy in a world of segmented financial markets, where only the agents who trade stocks encounter financial income risk. In such an economy, the welfare maximizing monetary policy attains the novel role of sharing the financial market risk traders face, among all agents in the economy. In order to do that, monetary policy reacts to financial market advances; it optimally expands in bad times for the financial markets and optimally tightens in good ones. A quantitative exercise shows large distributional losses for a 2% inflation targeting policy compared to the optimal policy, and also isolates risk sharing losses of similar magnitude with that of having business cycle fluctuations. In addition, our model suggests that optimal monetary policy is not concerned with stock price volatility, does not attempt to minimize it and the policy that does, involves welfare losses. It is though concerned, to some extent, with inflation stability, producing lower inflation volatility when compared to the constant money supply policy rule.

Keywords: limited participation, optimal monetary policy, financial risk sharing, stock price volatility

JEL Classification: E44, E52, G12