Monetary Policy and Stock Prices in a DSGE Framework

Is the Federal Reserve at all concerned with stock market performance, as the observation of its recent conduct might seem to suggest? Is there a theoretical scope for such a concern? This paper addresses both questions, presenting and estimating a small structural model that provides a theoretical rationale for looking at equity prices in conducting Monetary Policy. The focus is on the effects that stock market’s booms and busts might have on consumption: a Dynamic Stochastic General Equilibrium (DSGE) model of the business cycle is set up, in which consumer prices are sticky and an explicit role for equity prices is allowed for in the household optimization problem. An augmented forward-looking Taylor Rule that controls for stock prices accounts for the behavior of the policy maker. Maximum likelihood estimates of the structural parameters are computed through Kalman Filtering. The empirical evidence found does not provide a strong support to the view that the Federal Reserve has reacted to stock prices misalignments, suggesting that the ”wealth effect” channel by itself might not be sufficient to rationalize a possible concern in equity prices beyond their role in predicting future inflation and output dynamics. Moreover, analysis of the conditions for determinacy reveals that a positive reaction to stock prices, within this framework and under common assumptions about the sensitivity of demand to real interest rates, would imply multiple stable equilibria. In such a case, a revision in the expectations by itself would suffice to generate endogenous and persistent fluctuations. JEL classification: C22, E32, E52