Abstract
A recent paper by Carlstrom and Fuerst [“Asset Prices, Nominal Rigidities, and Monetary Policy,” Review of Economic Dynamics, Vol. 10, 2007, pp. 256-275] finds that monetary policy response to share prices is a source of equilibrium indeterminacy because an increase in inflation implies a high real marginal cost and low share prices in a sticky-price economy. We find that if the New Keynesian Phillips curve has a lagged inflation term caused by price indexation, this effect is weakened. Moreover, equilibrium indeterminacy caused by the monetary policy response to share prices never arises if all the firms that cannot re-optimize their prices follow price indexation.
Highlights
A paper by Carlstrom and Fuerst [1] shows that equilibrium indeterminacy arises if monetary policy responds to share prices in a standard sticky-price economy
We find that if the New Keynesian Phillips curve has a lagged inflation term caused by price indexation, this effect is weakened
Equilibrium indeterminacy caused by the monetary policy response to share prices never arises if all the firms that cannot re-optimize their prices follow price indexation
Summary
A paper by Carlstrom and Fuerst [1] shows that equilibrium indeterminacy arises if monetary policy responds to share prices in a standard sticky-price economy. The monetary policy response to share prices implicitly weakens overall reactions to inflation This is a source of equilibrium indeterminacy. It is shown that the effect of an increase in inflation on real marginal costs is weakened through the hybrid Phillips curve. Equilibrium indeterminacy caused by the monetary policy response to share prices never arises if all the firms that cannot re-optimize their prices follow price indexation. An increase in inflation increases the real marginal cost under the sticky-price setting without price indexation, since a fraction of firms cannot change their prices. Firms following price indexation can keep their real marginal cost constant in the long run since the past inflation reflects this increase in inflation.
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