Abstract
Empirical evidence points to moderate inflation during stock market booms. To explain it and study optimal monetary policy in such a situation, this paper develops a dynamic model with rational bubbles and nominal rigidities. The model features a financial cost channel through which the shadow cost of borrowing affects the marginal cost. A bubble-led boom mitigates firms' borrowing constraints and keeps inflation from rising by decreasing the shadow cost of borrowing. In this situation Ramsey-optimal monetary policy calls for tightening to curb the boom. Strict inflation targeting is counterproductive in the short run as it exacerbates the boom. For obtaining these results the financial cost channel and nominal wage rigidity are essential.
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