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

74 Pages Posted: 13 Aug 2020 Last revised: 15 Mar 2022

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

Yale School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 4 versions of this paper

Date Written: March 11, 2022

Abstract

We analyze optimal monetary policy and its implications for asset prices, when aggregate demand has inertia and responds to asset prices with a lag. If there is a negative output gap, the central bank optimally overshoots aggregate asset prices (asset prices are initially pushed above their steady-state levels consistent with current potential output). Overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but it accelerates the recovery. When there is a lower-bound constraint on the discount rate, overshooting becomes a concave and non-monotonic function of the output gap: the asset price boost is low for a deeply negative initial output gap, grows as the output gap improves over a range, and shrinks toward zero as the output gap improves further. This pattern also implies that good macroeconomic news is better news for asset prices when the output gap is more negative. Finally, we document that during the Covid-19 recovery, the policy-induced overshooting was large---sufficient to explain the high levels of stock and house prices in 2021.

Keywords: Monetary policy, aggregate demand inertia, lags, output gap, recovery, asset prices, overshooting, Wall/Main Street disconnect, Covid-19, interest rate lower bound, macroeconomic news, market bond portfolio, QE/LSAPs

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 (March 11, 2022). 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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