Working Paper: NBER ID: w27712
Authors: Ricardo J. Caballero; Alp Simsek
Abstract: We analyze optimal monetary policy and its implications for asset prices, when aggregate demand has inertia and responds to asset prices with a lag. If there is a negative output gap, the central bank optimally overshoots aggregate asset prices (asset prices are initially pushed above their steady-state levels consistent with current potential output). Overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but accelerates the recovery. When there is a lower-bound constraint on the discount rate, overshooting becomes a concave and non-monotonic function of the output gap: the asset price boost is low for a deeply negative initial output gap, grows as the output gap improves over a range, and shrinks toward zero as the output gap improves further. This pattern also implies that good macroeconomic news is better news for asset prices when the output gap is more negative. Finally, we document that during the Covid-19 recovery, the policy-induced overshooting was large—sufficient to explain the high levels of stock and house prices in 2021.
Keywords: monetary policy; asset prices; COVID-19 recovery; output gap
JEL Codes: E21; E32; E43; E44; E52; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimal monetary policy (E63) | Asset price overshooting (G19) |
| Negative output gap (E31) | Asset price overshooting (G19) |
| Negative output gap (E31) | Real rates reduction (E43) |
| Real rates reduction (E43) | Asset price increase (G19) |
| Asset price increase (G19) | Aggregate demand (E00) |
| Output gap improvement (E23) | Real rates increase (E43) |
| Real rates increase (E43) | Asset price reconnection with economic fundamentals (G19) |
| Good macroeconomic news (E60) | Asset price increase (G19) |
| Output gap improvement (E23) | Asset price boost (G19) |
| Asset price boost (G19) | Economic fundamentals reconnection (F69) |