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Optimal Monetary Policy and Rational Asset Bubbles

Jacopo Bonchi and Salvatore Nisticò

No 525, Working Papers from University of Milano-Bicocca, Department of Economics

Abstract: Using a New Keynesian model with stochastic asset market participation, we analyze the normative implications of bubbly fluctuations for monetary policy. We show that stochastic asset-market participation allows rational bubbles to emerge in equilibrium despite the fact that households are infinitely lived. A central bank concerned with social welfare faces an additional tradeoff implied by the effect of bubbly fluctuations on consumption dispersion across market participants, which makes, in general, strict inflation targeting a suboptimal monetary-policy regime. Deviations from inflation targeting are welfare improving in particular when the economy fluctuates around a balanced-growth path where equilibrium bubbles are small or absent, and the endogenous tradeoff is more stringent, requiring larger deviations of inflation/output gap to mitigate bubbly fluctuations in wealth and thus consumption inequality. The specific optimal monetary-policy response to bubbly fluctuations depends however on the intrinsic features of latter, and the associated effects on wealth inequality.

Keywords: Rational bubbles; Optimal monetary policy; Stochastic Asset Market Participation; Consumption dispersion (search for similar items in EconPapers)
JEL-codes: E21 E32 E44 E58 (search for similar items in EconPapers)
Pages: 47
Date: 2023-08, Revised 2023-08
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-mac and nep-mon
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