Monetary Policy and Stock Market Booms

Abstract

This chapter examines some of the traditional views on appropriate monetary policy and its relationship with stock market booms. Using historical data and model simulations for eighteen boom periods in the United States, it considers the interaction between monetary policy and asset price volatility and its implications for the stock market. It also asks whether monetary policy is partly responsible for stock market booms and whether it should actively seek to stabilize such booms. The chapter shows that if inflation is low during stock market bubbles, an interest rate rule that narrowly targets inflation actually destabilizes asset markets and the macroeconomy. By setting interest rates to target low inflation, central banks are actually setting real rates below the natural rate, giving rise to asset price bubbles. To reduce volatility in asset prices and the real economy, credit growth must be taken into account in the interest rate targeting rule.