Monetary Policy and Stock Market Booms

Lawrence Christiano, Cosmin Ilut, Roberto Motto, and Massimo Rostagno
CQER Working Paper 10-08
December 2010

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Historical data and model simulations support the following conclusion: Inflation is low during stock market booms, so an interest rate rule that is too narrowly focused on inflation destabilizes asset markets and the broader economy. Adjustments to the interest rate rule can remove this source of welfare-reducing instability. For example, allowing an independent role for credit growth (beyond its role in constructing the inflation forecast) would reduce the volatility of output and asset prices.

JEL classification: E42, E58

Key words: inflation targeting, sticky prices, sticky wages, stock price boom, DSGE model, New Keynesian model, news, interest rate rule

The paper was prepared for "Macroeconomic Challenges: the Decade Ahead," a symposium sponsored by the Federal Reserve Bank of Kansas City held in Jackson Hole, Wyoming, on August 26–28, 2010. The authors are grateful for discussions with David Altig, Gadi Barlevy, Martin Eichenbaum, Ippei Fujiwara, and Jean-Marc Natal and for comments from John Geanakoplos. The authors have also benefited from the advice and assistance of Daisuke Ikeda and Patrick Higgins. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Lawrence Christiano, Northwestern University and NBER, Department of Economics, 2003 Sheridan Road, Evanston, IL 60208, 847-491-8231, l; Cosmin Ilut, Duke University, Department of Economics, 213 Social Sciences Building, Box 90097, Durham, NC 27708-0097,; Roberto Motto, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany,; or Massimo Rostagno, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany,

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