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

75 Pages Posted: 13 Aug 2020 Last revised: 30 Jul 2021

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)

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Date Written: July 29, 2021

Abstract

We analyze optimal monetary policy when asset prices influence aggregate demand with a lag. In this environment, when there is a current or anticipated output gap, the central bank optimally overshoots asset prices (i.e., significantly reduces discount rates to increase asset prices). Asset price overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but it also accelerates the recovery. A more intense overshooting policy weakens the relationship between inflation and the output gap (i.e., it flattens the Phillips curve). We quantify the policy-induced overshooting through risk-free rates in the Covid-19 recession and find that actual overshooting significantly exceeded the overshooting implied by a Taylor rule benchmark. Our calibrated model suggests this additional overshooting substantially accelerated the recovery. Finally, we show that policy-induced overshooting, along with monetary policy constraints, can shed light on the cyclical variation in the response of asset prices to macroeconomic news.

Keywords: Monetary Policy, Output Gap, Recovery, Asset Prices, Overshooting, Wall/Main Street Disconnect, Inflation, Phillips Curve, Taylor Rules, Market-Bond Portfolio, COVID-19, Macroeconomic News, 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 (July 29, 2021). 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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