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Abstract We provide a continuous-time “risk-centric” representation of the New Keynesian model, which we use to analyze the interactions between asset prices, financial speculation, and macroeconomic outcomes when output is determined by aggregate demand. In principle, interest rate policy is highly effective in dealing with shocks to asset valuations. However, in practice monetary policy faces a wide range of constraints. If these constraints are severe, a decline in risky asset valuations generates a demand recession. This reduces earnings and generates a negative feedback loop between asset prices and aggregate demand. In the recession phase, average beliefs matter because they not only affect asset valuations but also determine the strength of the amplification mechanism. In the ex ante boom phase, belief disagreements (or heterogeneous asset valuations) matter because they induce investors to speculate. This speculation exacerbates the crash by reducing high-valuation investors’ wealth when the economy transitions to recession, which depresses (wealth-weighted) average beliefs. Macroprudential policy that restricts speculation in the boom can Pareto improve welfare by increasing asset prices and aggregate demand in the recession.
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Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect
ABSTRACT We analyzeoptimalmonetary policy and its implications for asset prices when aggregate demand has inertia. If there is a negative output gap, the central bank optimally overshoots aggregate asset prices (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 accelerates the recovery. When there is a lower bound constraint on the discount rate, 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.
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- Award ID(s):
- 1848857
- PAR ID:
- 10504760
- Publisher / Repository:
- Wiley-Blackwell
- Date Published:
- Journal Name:
- The Journal of Finance
- Volume:
- 79
- Issue:
- 3
- ISSN:
- 0022-1082
- Format(s):
- Medium: X Size: p. 1719-1753
- Size(s):
- p. 1719-1753
- Sponsoring Org:
- National Science Foundation
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