Asset Markets and Monetary Policy

Abstract

Monetary policy has pursued the concept of inflation targeting. This has been implemented in many countries. Here interest rates are supposed to respond to an inflation gap and output gap. Yet, recently monetary policy, in particular in the US after the subprime and the credit crises, the economy was challenged by severe disruptions of the financial market. Subsequently, academics have been in search of a type of monetary policy that does allow to respond to the financial market. A model of this type should also show how the financial market responds to monetary policy. This paper derives a rule that explains how monetary authorities should set the short term interest rate with regard to asset prices, inflation rate, risk aversion, market volatility, and rate of consumption from capital. Interesting is that the inflation rate needs to have a certain minimal level. If this rule is applied properly, then the capital consumption rate will remain controlled and the inflation rate will be kept on a minimal possible level. Empirical evidence is provided that supports these findings.

Keywords: interest rates, portfolio optimization, consumption, inflation, monetary policy, benchmark approach

JEL Classification: G10, G13