Optimal Monetary Policy and Rational Asset Bubbles

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.