Optimal Monetary Policy with Fundamental Shifts in Asset Prices

Abstract

This paper investigates optimal monetary policy in response to fundamental innovations that affect asset prices. The fundamental innovations considered include productivity, investment efficiency, taste and bankruptcy cost innovations. I find that a central bank can stabilise the economy well when faced with such innovations, without attempting to stabilise asset prices. However, in addition to the output gap and inflation, monetary policy must also take into consideration the effects of these shocks on the capital gap as well. The results are robust to the inclusion of a demand-side credit friction in the New Keynesian model, if this friction is small.