Rational Beliefs, Stock Market and Monetary Policy

Should Central Banks target asset prices? We answer the question by studying the efficacy of monetary policy when the economy and the stock market performances are affected by an endogenous shock due to diverse correlated rational beliefs. We adopt a perpetual youth model `a la Blanchard (1985) and Yaari (1965) with heterogeneous expectations based on the Rational Beliefs theory by Kurz (1994, 1997). In this framework, stock prices fluctuations affect real economy through two different channels: the financial wealth channel and the expectational channel. We simulate the model under both Rational Expectations and Rational Beliefs. Contrary to Bernanke and Gertler’s (1999) prescription, we find that a mild “leaning against the wind” strategy in stocks market is beneficial for both output-gap and inflation stabilization. Moreover, results under Rational Beliefs exhibit a higher volatility and the magnitude of responses to shock is amplified by beliefs dynamics. Widespread optimism boosts inflation as well as output-gap and generates a bubble in stock prices. However, the effect on the real economy of such exuberance might be reduced by a more “aggressive” policy.