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

76 Pages Posted: 25 Aug 2020 Last revised: 21 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: August 2020

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.

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect (August 2020). NBER Working Paper No. w27712, Available at SSRN: https://ssrn.com/abstract=3679705

Ricardo J. Caballero (Contact Author)

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Alp Simsek

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