Reassessing the Role of Stock Prices in the Conduct of Monetary Policy

Abstract

In a New Keynesian model with capital adjustment costs and exogenous sources of policy tradeoffs central banks should not respond to stock price movements; a policy that focuses on stabilizing inflation is close to optimal. However, a numerical procedure that solves for the optimal Taylor-type rule that responds to stock prices by using the typical approach adopted by the extant literature, which consists in searching a small multi-dimensional interval for desirable policy reactions to inflation, output and stock prices, can easily prescribe all possible qualitative reactions to stock prices. Therefore, the model highlights some pitfalls in a numerical study of stock prices and monetary policy that can explain and reconcile the conflicting policy prescriptions found in the literature.