Should monetary policy respond to stock prices? - Perspectives from behavioral macroeconomics
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School of Business |
Master's thesis
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Date
2023
Department
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Mcode
Degree programme
Economics
Language
en
Pages
70
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Abstract
This paper is a literature review aiming to answer whether monetary policy should respond to changes in stock prices in addition to inflation and output. The stock market is an integral part of the economy, as it can produce and accelerate shocks that affect output and inflation. Economists haven’t reached a clear consensus on whether responding to stock price movements with monetary policy would limit or increase macroeconomic instability. There are also differing views concerning equilibrium conditions in models that include explicit stock price responses. My method is to compare the views of standard new Keynesian macroeconomics and behavioral macroeconomics. The former has been mostly critical of stock price responses, whereas the latter has provided support to the idea. The approaches differ in that new Keynesian economics presupposes rational expectations, while behavioral economics assumes ‘bounded rationality’. I find that the latter assumption is more realistic, and therefore monetary policy should respond to stock prices up to some extent. However, stable inflation should remain the main objective for monetary policy.Description
Thesis advisor
Honkapohja, SeppoKeywords
monetary policy, stock market, behavioral macroeconomics, learning