Asset prices, nominal rigidities, and monetary policy

Abstract

Should monetary policy respond to asset prices? This paper analyzes this question from the vantage point of equilibrium determinacy. A central bank responding to asset prices is indirectly responding to firm profits. In a model with sticky prices, increases in inflation tend to lower firm profits so that a central bank responding to share prices implicitly weakens its overall response to inflation. This is the novel source of equilibrium indeterminacy highlighted in the paper.