Asset Prices and Optimal Monetary Policy Rules
38 Pages Posted: 16 Jul 2016 Last revised: 19 May 2017
Date Written: May 18, 2017
We construct a New Keynesian DSGE model that features financial frictions, investment frictions, long-run productivity risk, and Epstein and Zin (1989) preferences. The model successfully reproduces key features of both asset prices and macroeconomic quantities. Under this set up, we examine the implications of different monetary policy rules where the central bank responds to inflation, output and asset prices in the presence of productivity shocks, monetary policy shocks, and financial shocks. Our main result suggests that in the presence of these shocks, optimal monetary policy should react to asset prices over and above the inflation and output outlook in order to achieve greater macroeconomic and financial stability. This paper contributes to the current debate on how central bankers ought to respond to asset price volatility, in the context of an overall strategy for monetary policy.
Keywords: Optimal monetary policy, Asset pricing, Recursive utility, Long-run risk
JEL Classification: E37, E44, E52, E58, G12
Suggested Citation: Suggested Citation