Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect

Ricardo Caballero () and Alp Simsek

No 27712, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We analyze optimal monetary policy and its implications for asset prices, when aggregate demand has inertia and responds to asset prices with a lag. If there is a negative output gap, the central bank optimally overshoots aggregate asset prices (asset prices are initially pushed above their steady-state levels consistent with current potential output). Overshooting leads to a temporary disconnect between the performance of financial markets and the real economy, but accelerates the recovery. When there is a lower-bound constraint on the discount rate, overshooting becomes a concave and non-monotonic function of the output gap: the asset price boost is low for a deeply negative initial output gap, grows as the output gap improves over a range, and shrinks toward zero as the output gap improves further. This pattern also implies that good macroeconomic news is better news for asset prices when the output gap is more negative. Finally, we document that during the Covid-19 recovery, the policy-induced overshooting was large—sufficient to explain the high levels of stock and house prices in 2021.

JEL-codes: E21 E32 E43 E44 E52 G12 (search for similar items in EconPapers)
Date: 2020-08
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-ore
Note: AP EFG ME
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Published as RICARDO J. CABALLERO & ALP SIMSEK, 2024. "Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect," The Journal of Finance, vol 79(3), pages 1719-1753.

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Related works:
Journal Article: Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect (2024)
Working Paper: Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect (2022)
Working Paper: Monetary Policy and Asset Price Overshooting: A Rationale for the Wall/Main Street Disconnect (2022)
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