Central Banks, Stock Markets, and the Real Economy

Abstract

In this article, we summarize empirical research on the interaction between monetary policy and asset markets and review 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, the following occurs: (a) 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); (b) when the Fed is constrained, negative financial shocks cause demand recessions; (c) the Fed's response to aggregate demand shocks increases asset price volatility, but this volatility plays a useful macroeconomic stabilization role; (d) the Fed's beliefs about the future aggregate demand and supply drive the aggregate asset price; (e) macroeconomic news influences the Fed's beliefs and asset prices; (f) more precise news reduces output volatility but heightens asset market volatility; and (g) disagreements between the market and the Fed provide a microfoundation for monetary policy shocks and generate a policy risk premium.