The cost of capital, asset prices, and the effects of monetary policy

Abstract

The primary objective of this paper is to study the interaction between monetary policy, asset prices, and the cost of capital. In particular, we explore this issue in a setting where individuals face idiosyncratic risk. Incomplete information also provides a transactions role for money so that monetary policy can be studied. In contrast to standard monetary growth models which focus on the transmission of monetary policy to the demand for capital goods, we incorporate a separate capital goods sector so that the supply response to monetary policy is taken into account. Consequently, in contrast to the standard monetary growth model, monetary policy plays an important role in investment activity through the relative price of capital goods. Moreover, different sources of productivity can affect the degree of risk sharing. Although the optimal money growth rate falls in response to an increase in productivity in either sector of the economy, monetary policy should react more aggressively to the level of productivity in the capital sector.