Stock Prices and Incomplete Information: Implications for Monetary Policy

This paper derives optimal monetary policy when exogenous stochastic stock-price misalignments affect real activity, and analyzes what are the effects of incomplete in- formation in pursuing such optimal policy. Within a standard Dynamic New Keynesian (DNK) model with physical capital, two structural innovations are supposed to be driving stock prices dynamics: persistent productivity shocks affect the long-run component, while temporary stochastic mis- alignments are effective only in the short-term. The results suggest that, provided that it is able to identify in real time what is the source of the current dynamics of stock prices, an optimizing Central Bank should not respond to productivity shocks while a stock-price misalignment calls for intervention. In the case the Central Bankers have only access to limited information, they can’t isolate fundamental movements in stock prices from exogenous misalignments. In this case, and provided that the information available is efficiently used, the optimal mone- tary policy bias is large when the underlying shock is on productivity, while turns out to be very small in the case of a stochastic misalignment. http://dptea.luiss.edu/dptea/files/llwp27.pdf