Learning, Monetary Policy and Asset Prices

We present a New-Keynesian DSGE model where stock price áuctuations have real wealth e§ects on aggregate consumption. Financial markets feature a constant turnover between long-time traders (holding assets) and newcomers (entering the market with no wealth at all). We show that in this economy the wedge between the current and the expected level of aggregate consumption is driven not only by the ex ante real interest rate - as in the standard representative agent economy - but also by the market value of accumulated stock wealth. This demand-side linkage between the stock market and the macroeconomy introduces a scope for a response of monetary policy to stock prices. We assess under what conditions Taylor-type interest rate rules with the stock price index as an additional argument can shield the economy against non-fundamental áuctuations that are entirely driven by market sentiment. The analysis shows that the combination of weak stock market wealth e§ects on consumption and of an aggressive response of monetary policy to stock prices induces aggregate instability into the economy, in the form of multiple Rational Expectations Equilibria (REE) and instability under learning dynamics of the fundamental REE. For a given policy rule, endogenous áuctuations arise when dividends are, on average, small and agents have a long expected planning horizon (i.e. low turnover between long-time traders and newcomers). Under both conditions, the distortionary e§ects of stock prices on the intertemporal proÖle of optimal consumption are in fact quantitatively small. Our results hold both for the case of instrumental and of optimized (targeting) policy rules. With respect to the latter, we generalize the results by Evans and Honkapohja (2003), by emphasizing the role played by the wealth e§ects and the central bankís preference for stock market stability.