Working Paper: CEPR ID: DP18653
Authors: Ricardo Caballero; Alp Simsek
Abstract: This article summarizes empirical research on the interaction between monetary policy and asset markets, and reviews our previous theoretical work that captures these interactions. We present a concise model in which monetary policy impacts the aggregate asset price, which in turn influences economic activity with lags. In this context: (i) the central bank (the Fed, for short) stabilizes the aggregate asset price in response to financial shocks, using large-scale asset purchases if needed ("the Fed put"); (ii) when the Fed is constrained, negative financial shocks cause demand recessions, (iii) the Fed's response to aggregate demand shocks increases asset price volatility, but this volatility plays a useful macroeconomic stabilization role; (iv) the Fed's beliefs about the future aggregate demand and supply drive the aggregate asset price; (v) macroeconomic news influences the Fed's beliefs and asset prices; (vi) more precise news reduces output volatility but heightens asset market volatility; (vii) disagreements between the market and the Fed microfound monetary policy shocks, and generate a policy risk premium.
Keywords: Monetary Policy; Asset Prices; Transmission Lags; Financial Conditions Index; Fed's Beliefs; Interest Rates; Risk Premium; Aggregate Demand and Supply Shocks; Disagreements; Policy Mistakes
JEL Codes: G12; E43; E44; E52; E32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy (E52) | Aggregate asset prices (G19) |
| Aggregate asset prices (G19) | Economic activity (E29) |
| Monetary policy (E52) | Economic activity (E29) |
| Central bank stabilizes asset prices in response to financial shocks (E44) | Aggregate asset prices (G19) |
| Negative financial shocks (E44) | Demand recessions (E65) |
| Fed's beliefs about future economic conditions (E52) | Aggregate asset prices (G19) |
| Macroeconomic news (E60) | Aggregate asset prices (G19) |
| Disagreements between market expectations and Fed's beliefs (E52) | Policy risk premium (G22) |
| Fed induces asset price volatility (G19) | Aggregate demand shocks (E00) |