Optimal monetary policy and rational asset bubbles

Abstract

Within a tractable New Keynesian model with stochastic asset-market participation, we analyze the normative implications of bubbly fluctuations for monetary policy. For a welfare-maximizing central bank, bubbly fluctuations imply an endogenous tradeoff between stabilizing cross-sectional consumption dispersion and stabilizing inflation/output. Inflation targeting is thus a generally suboptimal monetary-policy regime, despite the “divine coincidence”. Optimal deviations from inflation targeting are larger if the economy fluctuates around a balanced-growth path with small or no equilibrium bubbles, in which case the endogenous tradeoff is more stringent. The specific optimal-policy response to bubbly fluctuations depends however on the intrinsic nature of latter, and the associated effects on consumption dispersion.