Stock Prices, Exchange Rates and Monetary Policy

This paper attempts to model the relationship between monetary policy and financial asset prices. We develop an aggregative model under forward-looking rational expectations to analyse the optimal monetary policy response to stock prices and exchange rates shocks. We first demonstrate that a model ignoring the impact of equity prices and exchange rates on aggregate demand leads to an overestimation of the optimal policy response to standard shocks. Second, we clearly point out that a correct assessment of the relation between optimal monetary policy and either equity prices or exchange rates necessitates a model including both kinds of financial prices simultaneously. Third, we show how these interactions between financial asset prices and monetary policy are affected by a particular form of coordination between monetary policy and fiscal policy, arising from a public debt solvency constraint.