Monetary Policy, Asset Prices and Adaptive Learning

Following recent episodes of financial distress, the interaction between monetary policy and asset price fluctuations has gained renewed attention. Here, we assess the role of asset price misalignments in monetary policy in an adaptive learning context. Our model first extends Bullard and Mitra (2002), including an additional role for asset prices. From the point of view of the E-Stability criterion, commonly used in the learning literature, we find that a response to stock prices is not desirable under both a forward expectations policy rule and an interest rate rule responding to contemporaneous values. Heterogeneous beliefs about the dynamics of asset price fluctuations, inflation and the output gap are introduced and we also evaluate an optimal monetary policy rule including a weight on asset prices. Overall we find that the Taylor principle remains important over all interest rate rules analysed and that central banks should act cautiously when considering the introduction of stock prices in monetary policy.