Stock Price Wealth Effects and Monetary Policy under Imperfect Knowledge

Departures from full-information rational expectation models give rise to stock price wealth effects which introduce inefficient cyclical fluctuations in the economy. Waves of optimism/pessimism affect beliefs and asset prices which influence aggregate demand through expectation-driven wealth effects. Monetary policy can play an important role in eliminating the non-fundamental effects of belief-driven asset price cycle: reacting symmetrically and transparently to stock prices increases welfare significantly compared to flexible inflation targeting strategies. A quantitative model estimated on US data shows that increasing interest rates by 12 basis points for every 100% rise in stock prices accomplish this goal. Moreover, a nonlinear reaction to stock prices only when capital gains exceed 7% delivers similar efficiency gains.