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Hanken School of Economics Working Papers, Hanken School of Economics

No 540:
Monetary Policy, Stock Price Misalignments and Macroeconomic Instability

Mikael Bask ()

Abstract: We augment the standard New Keynesian model for  monetary policy design with stock prices in the  economy and stock traders wh use a mix of fundamental  and technical analyses. The central question in  this paper is whether macroeconomic stability can  be achieved by an appropriate policy by the central  ank? In contrast with most of previous literature,  we argue that the central bank should augment the  interest rate rule with a term for stock price  misalignments since a determiate and stable rational  expectations equilibrium in the economy is then easier  to achieve. This equilibrium is stable under least  squares learning as well. Another interesting finding is  that inertia in monetary policy does not promote macroeconomic  stability when technical analysis plays a major role  in stock trading. Even worse, if the central bank in its  policy only indirectly responds to stock price misalignments  via its effect on the inflation rate, a combination of strong  inertia in monetary policy and a significant role for  technical analysis in stock trading will lead to macroeconomic instability.  

Keywords: Bubble Policy;  Fundamental Analysis;  Interest Rate Rule;  Least Squares Learning;  Macroeconomic Stability;  Stock Price Bubble;  Taylor Rule;  Technical Analysis; (follow links to similar papers)

27 pages, June 5, 2009

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