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Anastasia S. Zervou∗

Department of Economics, Texas A&M University, College Station, TX 77843 November 11, 2011

Abstract We explore the role of monetary policy in a world of segmented ﬁnancial markets, where only the agents who trade stocks encounter ﬁnancial income risk. In such an economy, the welfare maximizing monetary policy attains the novel role of sharing the ﬁnancial market risk traders face, among all agents in the economy. In order to do that, monetary policy reacts to ﬁnancial market advances; it optimally expands in bad times for the ﬁnancial markets and optimally tightens in good ones. In addition, our model suggests that optimal monetary policy is not concerned with stock price changes, does not necessarily minimize stock price volatility, and the policy that does, involves welfare losses. It is though concerned, to some extent, with inﬂation stability. JEL classiﬁcation: E44; E52; G12. Keywords: Limited Participation, Optimal Monetary Policy, Financial Risk Sharing, Stock Price Volatility.

Texas A&M University, 4228 TAMU, College Station, TX 77843, azervou@econmail.tamu.edu, http://econweb.tamu.edu/azervou/. I am very grateful to Stephen Williamson and to Costas Azariadis and James Bullard for their constructive comments. I also thank Jacek Suda, the entire Macro Reading Group at Washington University, seminar participants at Athens University of Economics and Business, Bank of Cyprus, University of Cyprus, University of Piraeus, Rice University and participants of the 2008 Missouri Economics Conference, 12th ZEI International Summer School on Monetary Macroeconomics, 7th Conference on Research on Economic Theory & Econometrics, 2009 North American Summer Meeting of the Econometric Society, 2009 European Meeting of the Econometric Society and 2010 Midwest Macro Meetings for helpful comments. I thank Yulei Peng for excellent research assistance. Finally, I thank the Olin Business School’s Center for Research in Economics and Strategy (CRES) for funding.

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Introduction

Should ﬁnancial market developments be a matter of monetary policy? This is a widespread concern among central bankers, especially aggravated by the recent 2007-2009 recession. The Federal Reserve and central banks of other developed countries seem to follow expansionary policies in response to ﬁnancial markets distress.1 Previous literature regarding how a monetary authority should respond to asset market advances focuses on policy responses to asset prices changes (e.g., Bernanke and Gertler, 2000; Bernanke and Gertler, 2001; Cecchetti et al., 2001; Gilchrist and Leahy, 2002 for a review on the topic; Faia and Monacelli, 2007). This paper studies some new aspects of the interaction of the monetary authority with the stock market. Speciﬁcally, it develops a cash-in-advance model and studies the risk-sharing implications of an optimal, welfare maximizing monetary policy in the presence of segmented ﬁnancial markets. In addition, it addresses the question of whether the optimal policy entails lower fundamentals originated stock price volatility when compared with other, widely used, monetary policy rules. We ﬁnd that this is not necessarily the case. Financial market segmentation is well documented (Mankiw and Zeldes, 1991; Guiso et al., 2002; Vissing-Jørgensen, 2002) and previously used in monetary models as an apparatus for studying the liquidity eﬀect (Alvarez et al., 2001), forms of non-neutrality of money (Williamson, 2005; Williamson, 2006) and a positive inﬂation target (Antinolﬁ et al., 2001).2 Our model is based on two implications of ﬁnancial market segmentation. First, as previous literature points out (Grossman and Weiss, 1983; Rotemberg, 1984; Lucas, 1990; Fuerst, 1992; Alvarez et al., 2001; Williamson, 2005; Williamson, 2006), monetary policy’s actions diﬀuse in the economy through the ﬁnancial system, aﬀecting those connected to the ﬁnancial system and those who are not in a diﬀerent manner. During open market operations the Federal Reserve interacts with large ﬁnancial institutions, directly aﬀecting ﬁnancial market participants; yet only indirectly aﬀecting non-participants, through price adjustments. For example, a monetary expansion beneﬁts those who are at the receiving

1 E.g., the Federal Reserve has been consistently decreasing the federal funds rate for almost all meetings from August 2007 until the end 2008, after which the target was too low to further decrease. See Bernanke (2009). Also, the marginal lending facility of the European Central Bank has been consistently decreasing through 2008-2009. 2 For its empirical importance see Landon-Lane and Occhino (2008) and Mizrach and Occhino (2008).

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end of the expansion; however, it increases prices and hurts those who are not connected to the ﬁnancial system. Thus, monetary policy has distributional eﬀects.3,4 Second, segmentation implies that only a fraction of the population is connected to the ﬁnancial system, so that only a fraction of the population is subject to ﬁnancial income risk. Although agents’ heterogeneity with respect to their connection to the ﬁnancial markets has been addressed in previous models (Grossman and Weiss, 1983; Rotemberg, 1984; Lucas, 1990; Fuerst, 1992; Alvarez et al., 2001; Williamson, 2005; Williamson, 2006), agents heterogeneity in terms of their ﬁnancial risk holding has not been yet explored and introduces additional considerations for monetary policy. Speciﬁcally, these distributional eﬀects that monetary policy exhibits under stock market segmentation aﬀect the way ﬁnancial income risk is shared between ﬁnancial market participants and non-participants. This happens automatically, through monetary policy’s usual operation. Our model studies how a monetary authority that cares equally about every agent, connected or not to the ﬁnancial markets, can perfectly share the ﬁnancial risk among all agents in the economy, maximizing in this way total welfare. Financial markets’ distress translates into lower dividend income; monetary policy optimally expands and beneﬁts ﬁnancial market participants. However, expansionary policy increases the price of the consumption good, decreasing the consumption of those who do not participate in the ﬁnancial markets. By contrast, monetary policy optimally tightens whenever ﬁnancial markets ﬂourish and dividend income is higher than expected. Such a reaction reduces the consumption of the ﬁnancial market participants, but also makes the consumption good more aﬀordable, increasing the consumption of non-participants. Answering the question asked above, whether and how monetary policy should respond to stock market advances, this paper suggests that monetary policy optimally expands in bad times for the ﬁnancial markets and tightens in good ones. This result assigns to monetary policy the novel role of sharing risk between heterogeneous agents of a particular type: ﬁnancial market

Early work on the distributional eﬀects of monetary policy involves models that are not very tractable (Grossman and Weiss, 1983; Rotemberg, 1984), although important attempts to obtain tractability resulted, contrary to this paper, in models that suggest limited role for monetary policy (Lucas, 1990; Fuerst, 1992). 4 There is of course large literature exploring the distributional eﬀects of inﬂation (Erosa and Ventura, 2002; Doepke and Schneider, 2006). In addition, recent work studies monetary policy regimes and the distributional eﬀects that the resulted inﬂation has (Meh et al., 2010). However, here we are exploring direct distribution eﬀects that monetary policy exerts.

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participants and non-participants. We further investigate the role of monetary policy in our model and compute stock price volatility and inﬂation volatility implied by the optimal monetary policy rule; we compare these volatilities with those implied by the constant money supply, inﬂation targeting and nominal interest rate peg policy rules. There is vast ﬁnance literature related to one or more of this model’s elements, studying stock price volatility (Allen and Gale, 1994; Guo, 2004; Guvenen and Kuruscu, 2006; Chien et al., 2011). We abstract from other issues this literature has considered (e.g., endogenous participation, idiosyncratic shocks or heterogeneous preferences), in order to focus on the importance of monetary policy regimes in generating stock price volatility. We ﬁnd that the optimal monetary policy does not necessarily produce lower stock price volatility compared to the other policy rules and thus, stock price changes should not be an integral part of monetary policy. Furthermore, the policy that minimizes stock price volatility also reduces welfare. In addition, our ﬁndings suggest that monetary policy targeting inﬂation does not take care of stock price volatility, in contrast to previous literature that does not account for ﬁnancial market segmentation (Bernanke and Gertler, 2000; Bernanke and Gertler, 2001). Optimal monetary policy does however care, to some extent, about keeping inﬂation stable; it produces half the inﬂation volatility that the constant money supply policy does. Also, contrary to previous literature (Allen and Gale, 1994) high ﬁnancial market participation does not necessarily associate with low stock price volatility. This is because in our model, stock price volatility depends on the type of policy rule the monetary authority follows. Recent work attempts to specify optimal monetary policy in limited participation New Keynesian models.5 Bilbiie (2008) focuses on assigning relative weights on output and inﬂation in an interest rate Taylor-type rule, and Andres et al. (2010) focuses on addressing trade-oﬀs between monetary authority’s stabilization goals. We use a very diﬀerent model to focus on the risk sharing role of optimal monetary policy and address the issue of how stock price volatility is aﬀected by monetary policy. Overall, this paper suggests that in the presence of segmented ﬁnancial markets monRelated topics have also been studied using full participation models, e.g., Challe and Giannitsarou (2011) develops a full participation asset pricing New Keynesian model in order to match the empirical ﬁndings of the stock price response to monetary policy shocks (Rigobon and Sack, 2004; Bernanke and Kuttner, 2005).

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etary policy should react to ﬁnancial market advances through channels that previous literature has ignored. Monetary policy attains the role of sharing ﬁnancial income risk between ﬁnancial market participants and non-participants. This policy is, to some extent concerned with inﬂation stability, but is not concerned with stock price volatility. The rest of the paper is organized as follows. Section 2 introduces the model economy and studies the competitive equilibrium and asset pricing. Section 3 describes the implications and role of the optimal monetary policy rule. Section 4 examines the stock price and inﬂation volatility for various policy rules. Section 5 concludes.

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2.1

**The Model Economy
**

Environment

The model economy consists of the goods market and three asset markets: nominal bond, stock and money market. The bond and stock markets are segmented, so that from a continuum of inﬁnitely lived households of measure one, only λ ∈ (0, 1) fraction participates in these markets although 1−λ does not. The stock market is introduced in a way similar to the Lucas (1978) model, i.e., participating agents receive a share of the stochastic dividend tree in proportion to the quantity of shares they hold. The bonds are introduced for examining the asset pricing of the model. All agents have identical preferences and seek to maximize:

∞

E0

t=0

β t u(ci ), t

where β is the discount factor with 0 < β < 1 and ci ≥ 0 denotes consumption at time t t by consumer of type i, with i ∈ {T, N }. Consumers’ types T and N are described below. We assume that u′ (.) > 0 and u′′ (.) < 0. The fraction 1 − λ of the population that does not participate in the ﬁnancial markets, or the non-traders (i = N ), receives every period a ﬁxed real endowment y N > 0 of the non-storable consumption good. The fraction λ of the population that participates in the ﬁnancial markets, or the traders (i = T ), receives every period a ﬁxed real endowment y T > 0 and a share of the stochastic real total dividend εt . We assume that there is a ﬁrm 5

which receives endowment εt in period t and distributes it as dividends to its share holders. The total dividend εt is random, has mean ε > 0 and is described as follows: ¯ εt = ε + ηt , ¯ (1)

2 where ηt is an iid shock with mean zero, variance σε and support [−¯, ∞). The stochastic ε

dividend is distributed among traders proportionally to the quantity of shares they bought. Consequently, traders have a risky component in their income, although non-traders collect only the ﬁxed endowment y N . Total income in this economy equals yt , yt ≡ εt + λy T + (1 − λ)y N , and thus mean income is given by: y = ε + λy T + (1 − λ)y N . ¯ ¯ (2)

In order for total output to be independent from the ﬁnancial market participation rate λ, we let the mean income of the traders equal that of the non-traders, i.e., y T +

ε ¯ λ

= yN .

Besides traders having a risky component in their income (although non-traders do not), there is one more diﬀerence between ﬁnancial market participants and non-participants. That is, ﬁnancial market participants are directly aﬀected by monetary policy’s actions. As is typical in the limited participation literature (Grossman and Weiss, 1983; Rotemberg, 1984; Lucas, 1990; Fuerst, 1992; Alvarez et al., 2001; Williamson, 2005; Williamson, 2006), this model reﬂects the fact that initially, open market operations aﬀect only the ﬁnancial sector of the economy. We employ this feature by having the monetary authority distributing transfers τt only to the traders, although the non-trades do not collect such transfers.6 The timing of the model is as follows. Agents enter period t with money balances mi ≥ 0 for type i ∈ {T, N }. At the beginning of the period the dividend shock εt is t realized, although given the cash-in-advance assumption, is not available to the traders until the end of the period. The ﬁnancial markets open ﬁrst (while the goods market remains closed) and the monetary transfer is distributed to the traders. In period t traders can sell the zt amount of stock they bought in period t − 1 and buy new stock at price

The cash provision to traders through this practice is equivalent to open market operations, which in fact aﬀects directly only the ﬁnancial market participants.

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qt . Bonds bought in period t − 1 at price st−1 < 1 expire and pay one unit of money in period t. Using their money holdings mT , the money from selling zt stocks, the returns t from holding bt bonds and the monetary transfer τt , traders can decide their new stocks and bonds purchases, zt+1 and bt+1 . After the ﬁnancial markets close, the goods market opens. In order for money to have value we assume that no agent consumes her own endowment and dividends but needs cash to ﬁnance consumption. Each household consist of a shopper-seller pair. The shopper receives the cash remaining after the transactions in the ﬁnancial markets complete and buys consumption good from other agents. The seller sells at price pt > 0 the real endowment y T and share zt+1 of the real dividend εt , if she is a trader, or just real endowment y N , if she is a non-trader. After the operations in the goods market conclude the seller and the shopper meet again, consume the consumption good the shopper purchased and keep the cash the seller received as money holdings for next period. That is, consumption is subject to the following cash-in-advance constraints, for traders and non-traders respectively: mT + qt zt + bt + τt ≥ pt cT + qt zt+1 + st bt+1 , t t mN ≥ pt cN . t t (3) (4)

The budget constraints for the traders and non-traders are given by equations (5) and (6) respectively: mT + qt zt + bt + τt + pt zt+1 εt + pt y T ≥ mT + pt cT + qt zt+1 + st bt+1 , t t+1 t (5)

where zt+1 εt is the real dividend payment distributed in period t (but available to use in period t + 1). mN + pt y N ≥ mN + pt cN . t t+1 t (6)

The monetary authority operates by setting the money growth each period t. Whenever money supply increases, the extra cash is distributed as transfers to the traders although

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whenever money supply decreases, traders are taxed. ¯ ¯ Mt = λτt + Mt−1 ¯ ¯ or equivalently, Mt = Mt−1 (1 + µt ), (7)

¯ where µt ∈ [−1, ∞) denotes money growth rate from time t − 1 to time t and Mt denotes money stock in period t, with a non-negative initial value. The extra money supplied at time t is distributed as transfers to the λ traders.

2.2

Equilibrium and Asset Pricing

We now explore the model’s equilibrium and asset pricing. In equilibrium the four markets operating in this economy clear. The real total endowment and dividend is consumed by traders and non-traders: εt + λy T + (1 − λ)y N = λcT + (1 − λ)cN . t t Using equation (2), which deﬁnes mean income, the goods market clearing condition becomes: y + εt − ε = λcT + (1 − λ)cN . ¯ ¯ t t Traders hold all shares of the ﬁrm and the stock market clears: λzt+1 = 1 ⇒ zt+1 = The bond market clears too: λbt = 0. Finally, the money market clears: ¯ λmT + (1 − λ)mN = Mt , t+1 t+1 ¯ where Mt is given by equation (7). The maximization problem of each household is subject to constraints (3) and (5) for the traders, and (4) and (6) for the non-traders. Because the ﬁnancial markets operate 8 (11) (10) 1 . λ (9) (8)

before the goods market does, holding money after the ﬁnancial markets close bears positive opportunity cost when the return on bonds or stocks is positive. Only the amount of money required for purchasing the desired amount of consumption good is held and the equilibrium is constructed for binding cash-in-advance constraints. Later we examine conditions which guarantee that traders’ cash-in-advance constraint binds. The budget constraints also bind, as usual. The implications for the budget constraints are: pt zt+1 εt + pt y T = mT , t+1 for traders, and p t y N = mN , t+1 (13) (12)

for non-traders. The above equations reveal that the cash balances with which the agents begin period t + 1 match the fraction of their wealth that the cash-in-advance constraints prevented them from using in period t. These are, the proceeds from selling in the goods market the real endowments, and for the case of traders, the real dividends distributed in period t. Furthermore, from the goods, stock, bond and money market clearing conditions, (8), (9), (10), (11) respectively, the cash-in-advance constraints (3) and (4) holding with equality and the money supply equation (7), we get a version of the quantity equation where velocity equals one, and total output equals the sum of the deterministic part, λy T + (1 − λ)y N = y − ε, and the stochastic part, εt : ¯ ¯ pt = ¯ Mt . y + εt − ε ¯ ¯ (14)

Equilibrium consumption for the two groups of agents is derived as follows. Combining the non-traders binding cash-in-advance constraint (4) with equation (13) and the goods price (14) we ﬁnd that the non-traders consumption is given as follows: cN = t pt−1 y + εt − ε ¯ ¯ 1 y=y ¯ ¯ . pt y + εt−1 − ε 1 + µt ¯ ¯ (15)

The above equation together with the market clearing condition for the goods market,

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**given by equation (8), imply that the traders’ consumption can be written as follows:
**

cT = t pt−1 1 τt y + εt − ε (εt−1 − ε)(1 + µt ) + y (λ + µt ) ¯ ¯ ¯ ¯ (¯ + (εt−1 − ε)) + y ¯ = . pt λ pt λ (¯ + εt−1 − ε)(1 + µt ) y ¯

(16)

Equations (15) and (16) reveal the distributional eﬀects that monetary policy exhibits in this segmented ﬁnancial markets model7 : Monetary policy aﬀects indirectly, through prices, all agents in the economy; however, it aﬀects directly, through transfers or taxes, only the ﬁnancial market participants. In an expansion, monetary policy creates an inﬂation tax for all households, but distributes monetary transfers only to the traders; traders’ consumption increases and non-traders’ consumption decreases. In contrast, in a tightening, consumption becomes cheaper for both types of agents; however, only the traders get taxed and thus their consumption shrinks, although non-traders’ consumption rises. Note also that monetary policy aﬀects risk sharing between traders and non traders. Any monetary policy rule that reacts to real activity aﬀects the risk sharing between the two groups of agents. In the next section we study how monetary policy can share this risk optimally. Also, notice how, in the case of limited participation, dividend income aﬀects the consumption of the two groups, assuming that monetary policy does not react to such a shock. The equilibrium consumption equations reveal that an increase in the current total dividends distributed, εt , implies lower price for the consumption good in period t, increasing consumption for both traders and non-traders. On the other hand, an increase in total real dividends distributed the previous period, εt−1 , decreases the price of the consumption good in period t − 1 and thus the value of the consumption good carried in the form of money balances from period t − 1 to period t. For iid dividend shocks, consumption in period t decreases for the non-participants although increases for the participants. The increase in traders’ consumption depends on the participation rate; the more participating agents there are, the smaller the share of the εt−1 shock each of them receives is. Therefore, the increase in traders’ consumption is negatively aﬀected by the participation rate. Finally, it is important to notice that because of the cash-in-advance constraint, the dividend εt is currently distributed but is not currently consumed. It is the previous period dividend

Market segmentation allows for monetary policy’s distributional eﬀects, which are not present under full ﬁnancial market participation

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εt−1 that is consumed in period t. While the above analysis did not require solving the maximization problem, the study of asset prices requires such a procedure. In particular the traders’ utility maximization problem needs to be solved, subject to the cash-in-advance constraints (3), (4) and budget constraints (5), (6). The ﬁrst order conditions imply that the price of the bond is determined as follows: βEt u′ (cT ) u′ (cT ) t+1 t = st . pt+1 pt (17)

Equation (17) describes the usual pricing of nominal bonds: the utility increments traders expect to receive in period t + 1, when the bond matures and pays back, equals the foregone utility they suﬀer from buying the nominal bond in period t. In addition, this equation reveals a Fisher eﬀect, so the nominal interest rate is given by the real interest rate, augmented by an expected inﬂation premium. Note also that a strictly positive multiplier associated with the traders’ cash-in-advance constraint (3), implies that st < 1, so the nominal interest rate is strictly positive. For the case of certainty the usual condition is required to satisfy this assumption, i.e., that money growth must be greater than the discount factor. The ﬁrst order conditions imply the following expression for the stock price: βEt u′ (cT ) u′ (cT ) t+1 t (qt+1 + pt εt ) = qt , pt+1 pt (18)

which evaluates that the discounted marginal utility expected in period t + 1, when the dividends are paid and the share can be traded again, equals the forgone utility incurred from purchasing the share at time t. We will return to the stock price and its volatility later, when we will apply various policy speciﬁcation in equation (18) and compare across them.

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3

Optimal Monetary Policy

In this section we study a new role for intermediation that optimal monetary policy acquires in our model. We consider a monetary authority that maximizes total welfare by choosing the money supply growth rate. We assume that monetary authority assigns equal weight to each agent, no matter to which group the agent belongs to. Then, λ weight is assigned to the group of traders and 1 − λ to the group of non-traders. The maximization problem is as follows:

∞

max E0

µt t=0

β t (λu(cT ) + (1 − λ)u(cN )). t t

The ﬁrst order conditions imply the following: λ u′ (cT ) t ∂cT ∂cN t + (1 − λ) u′ (cN ) t = 0. t ∂µt ∂µt (19)

From equations (15) and (16) which determine consumption in equilibrium, we can calculate the derivative of consumption with respect to money growth: ∂cN y + (εt − ε) ¯ ¯ y ¯ t =− , ∂µt y + (εt−1 − ε) (1 + µt )2 ¯ ¯ and ∂cT 1 − λ y + (εt − ε) ¯ ¯ y ¯ t = . ∂µt λ y + (εt−1 − ε) (1 + µt )2 ¯ ¯ Note that non-traders’ consumption decreases although traders consumption increases whenever monetary policy expands. This is because limited participation prevents the monetary authority from directing its transfers to all agents, but distributes them instead only among the agents who participate in the ﬁnancial markets. Expansionary monetary policy increases current goods price aﬀecting negatively all agents; the traders however, receive the monetary transfer and the positive eﬀect is stronger. Notice also that the higher the ﬁnancial market participation rate λ, the smaller the fraction of the monetary expansion each trader receives. Substituting the above equations into equation (19) we ﬁnd that optimal money growth

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is as follows: 1 + µ∗ = t y ¯ y + (εt−1 − ε) ¯ ¯ . (20)

The above expression reveals a new role for monetary policy, which is to share the ﬁnancial income risk that traders are exposed to, among all agents in the economy. When the total real dividend is low (lower than the total mean dividend ε) traders’ consump¯ tion decreases. Optimal monetary policy expands and increases traders’ consumption by distributing to them higher transfers. As monetary policy expands current goods price increases, reducing non-traders consumption. In contrast, whenever the total dividend is high (higher than the total mean dividend ε), traders’ consumption is high. Optimal mon¯ etary policy tightens by taxing traders; the goods price decreases causing the non-traders’ consumption to rise. Financial income risk is perfectly shared between ﬁnancial market participants and non-participants, through optimal monetary policy.8 Financial market segmentation exposes only participants to ﬁnancial income risk. In addition, it allows monetary policy to have distributional eﬀects and the power to undo this market failure,9 and share the dividend risk among all agents. Note that because of the cash-in-advance constraint, traders at time t consume the dividend of the previous periods, εt−1 . The only relevant eﬀect of εt in period t is through price changes, which aﬀect both types of agents. Then, optimal policy at time t chooses to react to total dividend distributed at time t − 1, because εt−1 is the source of diﬀerential eﬀects across the two groups, i.e., positive eﬀects for traders and negative for non-traders.10 As a result, this model suggests that optimal monetary policy responds to advances in the asset markets, however not in the way previous research have considered (e.g., Bernanke and Gertler, 2000; Bernanke and Gertler, 2001; Cecchetti et al., 2001; Gilchrist and Leahy, 2002; Faia and Monacelli, 2007). Here the monetary authority responds to real dividend

Modifying the model so the monetary authority to have intertemporal considerations would not make the Friedman rule optimal. This is because monetary authority has distributional considerations in this model. This is similarly to Williamson (2005). 9 We consider the case that limited participation is generated through entry, information, trading costs etc. Vissing-Jørgensen (2003) ﬁnds that these costs are very important for explaining ﬁnancial market segmentation 10 Following the standard CIA assumption and timing of Lucas (1982), we only allow cash to be used for consumption purchases. We have explored a version of the model where agents are allowed to use current real dividends for ﬁnancing current consumption. Then, optimal monetary policy reacts to current real dividends in the exact same way that reacts to lagged real dividends in equation (20).

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changes in order to redistribute wealth from the privileged ﬁnancial market participants who were fortunate to encounter good ﬁnancial markets conditions, to the rest of the population, or, from the rest of the population to the disadvantaged ﬁnancial market participants who were hit by bad ﬁnancial markets shocks. The above result holds for any concave utility function. In addition, it is not sensitive to the ﬁxed endowment assumption. In the case of random mean endowments y , optimal ¯ monetary policy would still share between the two types of agents the extra risk that participants hold, and increase in this way total welfare. Also note that in this model optimal monetary policy reacts to real shocks, without the assumption of price rigidities. This is because of redistribution concerns, similarly to Williamson (2005). In our paper we take limited participation as given and ignore the interesting complications that the participation decision would introduce in the model.11 If participation cost, e.g., entry cost, trading cost or lack of information, discourages a positive mass of agents to participate in the ﬁnancial markets, then ﬁnancial markets are segmented and our model suggests that monetary policy bears real eﬀects. If the monetary authority follows the optimal rule, the consumption of traders and non traders each period is given below: cN ∗ = cT ∗ = Yt = y + εt − ε. ¯ ¯ t t (21)

We see that optimal monetary policy shares perfectly the risk between the two groups. In addition, although we are using an exogenous participation framework, optimal monetary policy makes agents indiﬀerent between participating in the ﬁnancial markets or not. Precisely, the traders would vote for any policy with µt > µ∗ as such a policy would int crease their consumption relative to what they consume under the optimal monetary policy regime. On the contrary, the non-traders would vote for any policy with µt < µ∗ for the t same reason. Optimal monetary policy equates consumption of the two groups and makes agents indiﬀerent between participating or not in the ﬁnancial markets. Finally, note that contrary to Bilbiie (2008), the optimal monetary policy in this model

Alvarez et al. (2002) and Khan and Thomas (2007) have thoroughly examined cases of endogenous participation.

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does not depend on the participation rate. This is true because monetary authority has direct eﬀects on the same group of agents that faces the dividends risk. It is the traders’ group that is exposed to ﬁnancial income risk; the same group is directly aﬀected by monetary policy. However, for monetary policy to have any real eﬀect, the limited participation assumption is necessary. Hence, as soon as ﬁnancial markets are segmented, no matter to what extent, monetary policy can operate in such a way that everybody shares and consumes the total output and becomes indiﬀerent between participating or not in the ﬁnancial markets. Our model implies that monetary policy aﬀects the risk sharing between ﬁnancial market participants and non-participants automatically, through its usual function. We suggest that policy makers should consider the direction of responses the model proposes in order for the redistribution from one group of agents to another be welfare improving. Of course this does not mean that monetary policy does not have other considerations, which our parsimonious model has intentionally ignored in order to focus on this new one, the ﬁnancial income risk sharing. In addition, we suggest that monetary policy is the relevant policy to consider for sharing ﬁnancial income risk. As previously suggested (e.g., Taylor, 2000), monetary policy does not require special design of tax scheme and takes less time and resources to implement than ﬁscal policy. In our case, monetary policy aﬀects ﬁnancial income risk sharing automatically, through its usual operation, taking no extra time or resources to implement.

4

Stock Price and Inﬂation Volatility

Given that previous literature on monetary policy’s response to ﬁnancial market advances has been focused on exploring whether or not monetary authority should consider assets price changes in deciding its instruments (e.g., Bernanke and Gertler, 2000, 2001; Cecchetti et al., 2001; Gilchrist and Leahy, 2002; Faia and Monacelli, 2007), we study the implications for stock price volatility that monetary policy has in our model. In additions, we study monetary policy’s implications for inﬂation volatility. In Section 4.1 we compute the stock price volatility for four policy rules: optimal, constant money supply, inﬂation targeting and nominal interest rate pegging. We ask 15

the question whether optimal monetary policy implies lower stock price volatility when compared to the other, frequently cited policy rules, and we ﬁnd that this is not necessarily the case. Section 4.2 examines the inﬂation volatility that the above monetary policy rules produce. We ﬁnd that optimal monetary policy is to some extent concerned with inﬂation volatility, but does not coincide with the policy that minimizes inﬂation volatility. In addition, we derive the policy rule associated with minimal stock price volatility and compute the welfare loss caused by implementing that policy instead of the optimal one. The analysis suggests that the welfare maximizing monetary policy does not attempt to minimize stock price volatility, and thus, stock price changes should not be an integral part of monetary policy. This analysis, however, does not suggest that monetary policy should not react to advances in the stock market. On the contrary, as analyzed in Section 3, optimal monetary policy reacts to dividend shocks by tightening in good times for the ﬁnancial markets and expanding in bad, in order to perfectly share ﬁnancial income risk. For convenience, we have summarized and discussed our main conclusions from this section, so the reader may refer directly to Section 4.3.

4.1

Stock Price Volatility

For the analysis that follows we need to specify a utility representation in order to compute explicitly the stock price and its variance. We use the logarithmic utility function.12 We ﬁrst calculate the real stock price, qt = ˆ

qt pt ,

using equation (18). The recursive solution,

**assuming that there are no bubbles so that the transversality condition holds, is as follows:
**

∞

q t = Et ˆ

j=1

βj

cT pt+j−1 t εt+j−1 . cT t+j pt+j

That is, we can write the stock price as the expected discounted value of all future dividends. After substituting the expressions for the goods price (14) and traders’ consumption (16), we ﬁnd the following expression for the stock price:

∞

q t = Et ˆ

j=1

12

βj

y + εt − ε ¯ ¯ (εt−1 − ε)(1 + µt ) + y (λ + µt ) ¯ ¯ εt+j−1 . (¯ + εt−1 − ε)(1 + µt ) (εt+j−1 − ε)(1 + µt+j ) + y (λ + µt+j ) y ¯ ¯ ¯

(22)

Similar conclusions are reached for a constant relative risk aversion function.

16

In the examples that follow we compute the variance of the stock price for a choice of policy rules and compare the results. We ﬁrst compute the stock price under the assumption that monetary policy is conducted optimally, following the optimal rule (20). We linearize around the dividend mean value, ε = λ(¯ − y T ), and ﬁnd the unconditional variance of the stock price for the optimal ¯ y monetary policy rule: Var(ˆt ) = q∗

2 β 2 σε [(1 − β)¯ + λ(¯ − y T )]2 , y y (1 − β)2 y 2 ¯

(23)

2 where as discussed earlier, σε is the variance of the total dividend shock.

A positive shock in current dividends under the optimal monetary policy rule would make traders want to acquire more shares, increasing the stock price. Higher dividend volatility in (23) translates into higher stock price volatility. Furthermore, under optimal monetary policy agents’ consumption equals aggregate output, which is not aﬀected by the ﬁnancial markets’ participation rate (see equation (21)). However, higher participation increases the mean total dividend, which in turns positively aﬀects the stock price and its variance. We now compare the volatility produced by the optimal monetary policy rule with that produced by the zero money growth rule. To compute the latter, we substitute µt = 0 for every period, in the real stock price equation (22) and linearize around the iid dividend shocks. Stock price volatility for a monetary authority that does not change its money supply is: Var(ˆt ) = q µ=0

2 β 2 σε {(1 − λ)2 (¯ − y T )2 + [λ(¯ − y T ) + (1 − β)y T ]2 }. y y (1 − β)2 y 2 ¯

(24)

Higher dividend volatility translates into higher stock price volatility. However, the eﬀect of the ﬁnancial market segmentation on the stock price and its variance are ambiguous and depend on the parameter values. Comparing equations (23) and (24) is not straightforward. To illustrate that optimal monetary policy is not necessarily associated with low stock price volatility we use the following example (for convenience, we summarize the parameter values in Table 1). For

17

Parameter Mean income Trader’s endowment Total dividend variation Discount factor

Symbol y ¯ yT σε β

Value 1 0.9 0.06 0.9

Table 1: Parameter Values

y = 1, y T = 0.9, β = 0.9 and σε = 0.06, Figure 1 shows that there is a critical value for the ¯ participation rate λ below which optimal monetary policy produces less volatility than the constant money supply policy, and above which optimal monetary policy generates higher volatility.13 For a ﬁnancial market participation rate of λ = 0.35 it is true that the optimal monetary policy implies lower stock price volatility than the constant money supply policy; however, this result reverses as the ﬁnancial market participation increases.14 We now explore the inﬂation targeting policy and its implications for stock price volatility. Inﬂation for any monetary policy rule µt is given below: πt = pt − pt−1 (¯ + εt−1 − ε)(1 + µt ) y ¯ = − 1, pt−1 y + εt − ε ¯ ¯ (25)

**¯ and for inﬂation target πt = π the corresponding monetary policy action is:
**

¯ 1 + µπ = (1 + π ) ¯ t

y + εt − ε ¯ ¯ . y + εt−1 − ε ¯ ¯

(26)

This equation implies that whenever current dividends are low compared to the previous period, inﬂationary pressure increases. A monetary authority aiming in attaining its inﬂation target reduces money supply and reduces inﬂation back to its target level. To derive the stock price variance for the inﬂation targeting monetary policy rule, we

¯ linearize the real stock price (22) for this policy µt = µπ , around the mean of the iid t

13

σε = 0.06 is between Shiller (1981)’s estimates of 0.01481 and 0.09828, based on two diﬀerent data

sets.

14 λ = 35% is approximately the percentage of the US population that Vissing-Jørgensen (2002) classiﬁes as bondholders.

18

Stock Price Variance 0.012 0.01 0.008 0.006 0.004 0.002 0.2 0.4 0.6 0.8 1 Λ

Figure 1: Stock price volatility of optimal (large-dashed line), constant money supply (solid line), π = 2 ¯ 2 percent inﬂation targeting (small-dashed line) and nominal interest rate peg at r + 1 = β (thick line) policy ¯ rules, for the parameter values given in Table 1.

**dividend shocks. The following expression is derived:
**

¯ Var(ˆt ) = qπ 2 β 2 σε [λ(1 + π )(¯ − y T ) + (1 − β)(λ + π )¯]2 ¯ y ¯ y . (1 − β)2 y 2 ¯ (λ + π )2 (1 + π )2 ¯ ¯

(27)

An increase in the variance of the dividend shock increases the volatility of the stock price. The eﬀect of the degree of segmentation is not clear though, as it has ambiguous eﬀects on consumption under this policy rule. Given the speciﬁc inﬂation target that the monetary authority chooses, we can compare the stock price volatility that the inﬂation targeting policy produces with that of the optimal and constant money supply policies. For example, compared to the optimal policy, a zero inﬂation targeting policy produces always higher stock price volatility. This is because of limited ﬁnancial market participation, although under full participation these two polices generate the same amount of stock price variance. As a second example we consider the policy implied by setting inﬂation target equal to π = 2 percent. We use the same parameter values as before, summarized in Table 1. ¯ We see in Figure 1 that choosing the policy that produces the least stock price variability depends crucially on the ﬁnancial market participation rate and on the other parameter values.

19

Another example of policy rule we consider is that of the nominal interest rate peg. By substituting in the equation for bonds price (17), the equilibrium price level (14), and traders’ consumption (16), the bond price becomes: s t = Et β y + εt − ε ¯ ¯ (εt−1 − ε)(1 + µt ) + y (λ + µt ) ¯ ¯ . (¯ + εt−1 − ε)(1 + µt ) (εt − ε)(1 + µt+1 ) + y (λ + µt+1 ) y ¯ ¯ ¯

¯ Linearizing the expression inside the expectation around µt+1 = µt = µ = 0 and εt = εt−1 = ε, and assuming that all shocks are iid and uncorrelated to each other, the nominal ¯ interest rate, 1 + rt = 1 + rt =

1 st−1 ,

equals:

λ¯ y . βλ¯ − β(1 − λ)(εt−1 − ε) + β(1 − λ)(εt−2 − ε) + β(1 − λ)¯µt−1 − β y Et−1 (µt ) y ¯ ¯ y ¯ (28)

Before we explore the stock price implications of the nominal interest rate peg policy, we ﬁrst examine the liquidity eﬀect of the model. Diﬀerentiating the above expression with respect to current money growth we see that

∂rt ∂µt−1

< 0. Furthermore, this derivative

becomes zero when there is full participation in the ﬁnancial markets, signifying the liquidity eﬀect. As in Alvarez et al. (2001), full participation implies that the only way monetary policy aﬀects the nominal interest rate is through expected inﬂation, i.e.,

∂rt ∂Et−1 µt

> 0.

**We compute the money supply policy implied by pegging the nominal interest rate at level r + 1 = ¯
**

1 β(1−¯) , µ

computed by evaluating the nominal interest rate in equation (28) for

mean values of the shocks, i.e., µt−1 = µt = Et−1 (µt ) = µ and εt−2 = εt−1 = ε. Equating ¯ ¯ the nominal interest rate target r to equation (28) we ﬁnd the monetary policy rule that ¯ pegs the nominal interest rate at level r : ¯

¯ ¯ 1 + µr = (1 + µ) + t

εt − εt−1 . y ¯

(29)

The above equation reveals that whenever the dividend shock consumed in the current period is high, i.e., ηt−1 = εt−1 − ε > 0, traders are prompt to buy more assets and the ¯ price of the bond rises. A monetary authority that aims keeping the nominal interest rate at a speciﬁc level would then tight and bring the nominal interest rate back to its target. In addition, whenever ηt = εt − ε > 0, future consumption is expected to rise; traders tend to ¯

20

buy fewer assets during the current period, forcing the price of the bond to fall. In order to keep the nominal interest rate at its target, monetary authority reacts by increasing money supply. Linearizing as usual around ε = λ(¯ − y T ) and assuming iid dividend shocks we ﬁnd ¯ y

¯ the stock price variance for the interest rate pegging policy, µ = µr , using the real stock

price equation (22):

2 λ2 (1 − λ)2 (¯ − y T )2 µ2 β 2 σε y ¯ 2 y2 2 (1 + µ)4 (1 − β) ¯ (λ + µ) ¯ ¯

¯ Var(ˆt ) = qr

(30)

{λ(¯ − y T )[1 + λ¯ + β µ(1 + µ)] + (1 − β)¯(λ + µ)(1 + µ)}2 y µ ¯ ¯ y ¯ ¯ + . 2 (1 + µ)4 (λ + µ) ¯ ¯ The monetary authority’s choice of interest rate peg, combined with the parameters values will determine whether or not this policy creates higher stock price volatility than the other policies considered. We ﬁrst examine the example of pegging the equilibrium rate, r = ¯

1 β,

derived by setting µ = 0. It turns out that the stock price variance when ¯

**pegging the equilibrium rate is equal to this produced by targeting zero inﬂation, i.e.,
**

¯ ¯ Var(ˆt ) = Var(ˆt =0 ), which in turn is higher than the stock price variance produced under qr qπ

**the optimal monetary policy speciﬁcation, as we explained earlier.
**

2 As a second example we consider a monetary authority which pegs a rate of r + 1 = β . ¯

Using for the rest of the parameters the same values as before, summarized in Table 1, we see in Figure 1 that depending on the parameter values, a diﬀerent policy produces the least stock price volatility. Overall, in our model, it is not the case that the optimal monetary policy is in general associated with minimal stock price volatility. We also derive the policy rule that a monetary authority interested in minimizing stock price volatility would implement. Then we calculate the welfare loss that this policy produces compared to the optimal policy. We consider a central bank that reacts to the distributed dividends in the previous and current

¯ period, εt−1 and εt . Speciﬁcally, we derive a linear function f (.), where f (εt−1 , εt ) = µq , t ¯ and µq is the money growth associated with minimal stock price volatility. t

**We substitute in equation (22) the monetary rule associated with minimum stock price
**

¯ volatility, µt = µq . Then, we linearize around the mean total dividend and ﬁnd the lint

21

earized expression for the stock price, as given below: βε ¯ 1 + f (¯) + y f1 (¯) ε ¯ ε + β ε(1 − λ) ¯ ηt−1 (1 − β)[1 + f (¯)] ε (1 − β)¯[λ + f (¯)][1 + f (¯)]2 y ε ε [λ + f (¯)][1 + f (¯)] + (1 − λ)¯f2 (¯) ε ε y ε y [λ + f (¯)] − ε[1 + f (¯)] − εy f1 (¯) ¯ ε ¯ ε ¯¯ ε +β (1 − β)¯[λ + f (¯)][1 + f (¯)]2 y ε ε y [λ + f (¯)][1 + f (¯)] ¯ ε ε ηt ,

qt¯ ≃ ˆq

+ βε ¯

where f (¯) is the money growth rate when the dividend shocks εt−1 , εt equal to their ε ε ε mean, and f1 (¯), f2 (¯) are its ﬁrst derivatives with respect to the ﬁrst and second argument respectively, evaluated at the mean of the dividends shocks. Also, ηt is deﬁned in equation (1). Letting the above expression be invariant, and by assuming that mean money growth is zero, we can ﬁnd the slope of the money growth function that minimizes stock price volatility, with respect to the two dividend shocks: f1 (¯) = − ε 1 λ[¯ + (1 − β)¯] ε y and f2 (¯) = − ε . y ¯ (1 − λ)¯y ε¯

We consider the case of a linear monetary policy rule, which is as follows: 1 λ[¯ + (1 − β)¯] ε y ¯ ¯ ¯ 1 + µq = 1 − (εt−1 − ε) − (εt − ε). t y ¯ (1 − λ)¯y ε¯ We compare this policy to the optimal one, in terms of total welfare:

∞ ¯ W q − W ∗ = E0 t=0 q q β t [λu(cT,¯) + (1 − λ)u(cN,¯)] − t t t=0 ∞

(31)

β t [λu(cT ∗ ) + (1 − λ)u(cN ∗ )], t t

¯ where Wt∗ and Wtq denote total welfare implied by the optimal monetary policy and the

stock price targeting rule respectively. After substituting for consumption implied by each policy, using equations (15), (16) and (21), the logarithmic utility implies the following expression for total welfare loss:

∞ ¯ W q − W ∗ = E0 t=0

β t λ ln

¯ ¯ (¯ + εt−1 − ε)(1 + µq ) − (1 − λ)¯ y ¯ y (¯ + εt−1 − ε)(1 + µq ) y ¯ t t − ln λ¯ y y ¯

.

The above expression shows that there is no welfare loss if there is full participation in the ﬁnancial markets or the total dividend shocks are always equal to their mean. However,

22

any other case produces positive welfare loss. Using the parameter values from Table 1 and ﬁnancial market segmentation parameter λ = 0.35 we ﬁnd welfare losses for both positive and negative ﬁnancial shocks. For a positive ﬁnancial shock of 10 percent above the mean in period t, the welfare loss in period t and period t + 1 from implementing stock price targeting versus the optimal policy rule15 adds to 1.43 percent. Calculated similarly, a negative ﬁnancial shock of 10 percent below its mean in period t reduces welfare by 1.37 percent. This welfare loss is increasing with the rate of ﬁnancial segmentation, suggesting that the optimal monetary policy rule becomes more vital in economies with high ﬁnancial market participation.

4.2

Inﬂation Volatility

In this section we examine the inﬂation volatility that the optimal, constant money supply, inﬂation targeting, interest rate pegging and stock price targeting policies imply, and we make comparisons across them. The general expression for inﬂation is given by equation (25), in which we substitute the relevant policy rule. To compute the inﬂation variance implied by the various policies, we ﬁrst linearize the inﬂation equations around the mean dividend value ε and then calculate ¯ the variance for iid dividend shocks, as follows:

∗ Var(πt ) = 2 σε , y2 ¯

**for the optimal monetary policy rule;
**

µ=0 Var(πt ) = 2 2 σε , 2 y ¯

**for the constant money supply policy rule;
**

π ¯ Var(πt ) = 0,

We look at two consecutive periods because the stock price targeting policy involves responses in two periods.

15

23

**for the zero inﬂation targeting policy rule;
**

r ¯ µ Var(πt ) = 2¯2 2 σε , y2 ¯

**for the nominal interest rate pegging policy rule, and
**

q Var(πt¯) =

(1 − β)λ¯ + ε y ¯ (1 − λ)¯ ε

2

2 σε , 2 y ¯

for the stock price targeting monetary policy rule. Inﬂation variance is minimized, as expected, under the inﬂation targeting policy. Additionally, the optimal policy is always associated with less inﬂation volatility than the constant money supply policy. The latter is true because under the optimal policy the dividend shocks from the previous period are oﬀset, while under constant money supply they are not. These shocks increase the volatility of inﬂation. Furthermore, a monetary authority pegging the interest rate at its equilibrium level, r+1 = ¯

1 β,

implies zero inﬂation volatility. Using the parameter values in Table 1 and for

any other peg between zero and one, this policy implies lower inﬂation volatility than the optimal and constant money supply ones. Finally, using the parameter values in Table 1 and for λ = 0.35, the optimal monetary policy implies lower inﬂation volatility than the stock price targeting policy.

4.3

Discussion

In this section we examined the implications that optimal monetary has for stock price volatility and inﬂation volatility, and compare with various monetary policy rules. It is clear from our analysis that the optimal monetary policy does not necessarily associate with lower stock price volatility or inﬂation volatility when compared to other policy rules considered. There are policies diﬀerent from the optimal one that produce minimal stock price volatility and inﬂation volatility. The evidence on whether or not monetary policy should respond to asset prices is conﬂicting (Cecchetti et al., 2001; Gilchrist and Leahy, 2002; Faia and Monacelli, 2007). We ﬁnd that the optimal monetary policy rule does not produce necessarily lower stock

24

price volatility than what the constant money supply policy does; it produces lower stock price volatility than the inﬂation targeting policy for some targets and from the interest rate peg policy for some pegs. The results depend on the parameter values and on the choice of inﬂation target and peg. We conclude that the welfare maximizing monetary policy is not in general concerned with minimizing stock price volatility. Previous literature suggests that monetary policy targeting inﬂation, takes care of stock price volatility (Bernanke and Gertler, 2000; Bernanke and Gertler, 2001). This paper provides some counter examples: for the same parameter values, a policy that minimizes stock price volatility produces high inﬂation volatility and a policy that minimizes inﬂation volatility produces high stock price volatility. This is because, ﬁrst, in our model we consider dividend type of shocks. Currently distributed dividends decrease current prices and inﬂation (through equations (14) and (25)), so a monetary authority targeting inﬂation expands after high current dividend shocks (see equation (26)). However, currently distributed dividends increase the stream of future consumption, increasing the stock price, so a monetary authority targeting stock prices tightens after high current dividend shocks (see equation (31)). In addition, in our model we take into account limited ﬁnancial market participation, which aﬀects the stock price targeting policy, but not the inﬂation targeting policy. Because it is aﬀected diﬀerently by ﬁnancial market participation and dividend shocks, the inﬂation targeting policy (that minimizes inﬂation volatility) does not necessarily minimize stock price volatility. Furthermore, we see in Figure 1 that increased participation does not necessarily imply lower stock price volatility. This observation is in contrast to previous literature (Allen and Gale, 1994) arguing that high variability in stocks price is encouraged by low stock market participation. If monetary policy actions are taken into account, as they are in this model, the eﬀect of the increased ﬁnancial market participation on stock price volatility becomes more complicated, and depends on the speciﬁc monetary policy followed. Finally, we derive a monetary policy rule that aims in keeping constant the stock price and we ﬁnd that there is welfare loss from implementing this rule instead of the optimal one. The welfare loss disappears under full ﬁnancial market participation, revealing the misleading conclusions one can reach by omitting limited ﬁnancial market participation

25

from welfare comparisons of monetary policy rules. Concerning inﬂation volatility we ﬁnd that the optimal monetary policy always produces lower inﬂation volatility than what the constant money supply policy rule does. That is, the welfare maximizing monetary policy is concerned, to some extent, with sustaining stable inﬂation.

5

Concluding Remarks

In conclusion, our model suggests that monetary policy should respond to stock market advances, but for reasons previous literature has not considered. Because of ﬁnancial market segmentation a novel role arises for monetary policy in order to maximize welfare, that of sharing ﬁnancial income risk only the ﬁnancial market participants face, among all agents in the economy. Monetary policy optimally expands in bad times for the ﬁnancial markets and optimally tightens in good times for the ﬁnancial markets. This policy equalizes consumption of the two groups and agents, if given the choice, would be indiﬀerent between participating or not in the ﬁnancial markets. These results hold for any concave utility function and are not sensitive to the degree of market segmentation. We also examine optimal monetary policy’s implications for stock price volatility and inﬂation volatility, and compare with other, commonly cited monetary policy rules. Our analysis suggests that optimal monetary policy is not concerned with asset price volatility, but is concerned, to some extent, with keeping inﬂation stable.

26

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