Optimal Monetary Policy with Wealth Effects

This paper analyses optimal monetary policy using a structural model of the economy that allows for the effect of changes in asset prices on aggregate demand. The important feature is that monetary policy is assumed to affect output and inflation not only directly via firms’ level of investment but also via consumption through realized capital gains. Solving the Central Bank’s dynamic optimization problem, we derive an optimal interest rule where nominal interest rates are set according to concurrent inflation and the output gap. When wealth effects are considered though, the optimal response to inflation is lower, as compared to the conventional Taylor rule.