Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect

37 Pages Posted: 13 Aug 2020

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Alp Simsek

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

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Date Written: August 12, 2020

Abstract

We analyze optimal monetary policy when asset prices influence aggregate demand with a lag (as is well documented). In this context, as long as the central bank's main objective is to minimize the output gap, the central bank optimally induces asset price overshooting in response to the emergence of a negative output gap. In fact, even if there is no output gap in the present but the central bank anticipates a weak recovery dragged down by insufficient demand, the optimal policy is to preemptively support asset prices today. This support is stronger if the acute phase of the recession is expected to be short lived. These dynamic aspects of optimal policy give rise to potentially large temporary gaps between the performance of financial markets and the real economy. One vivid example of this situation is the wide disconnect between the main stock market indices and the state of the real economy in the U.S. following the Fed's powerful response to the COVID-19 shock.

Keywords: Monetary policy, output gap, asset prices, overshooting, Wall/Main Street disconnect, COVID-19

JEL Classification: E21, E32, E43, E44, E52, G12

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect (August 12, 2020). Available at SSRN: https://ssrn.com/abstract=3672413 or http://dx.doi.org/10.2139/ssrn.3672413

Ricardo J. Caballero (Contact Author)

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Alp Simsek

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