Asymmetric monetary policy towards the stock market: A DSGE approach

• Recent empirical evidence has suggested that US monetary policy reacts to stock prices only when these are falling.
• We study the effects of an asymmetric monetary policy reaction to stock prices in a DSGE model.
• Booms in output and inflation are amplified, while recessions are dampened.
• An asymmetric policy further causes an anticipation-driven boom in asset prices.
• Such a policy may be able to correct for asymmetric effects of stock prices on the macroeconomy.

In the aftermath of the financial crisis, it has been argued that a guideline for the design of the future policy framework should be to take the ‘a’ out of ‘asymmetry’ in the way monetary policy deals with asset price movements. Recent empirical evidence has suggested that the Federal Reserve may have followed an asymmetric policy towards the stock market in the pre-crisis period. According to these findings, monetary policy in the US before the crisis involved a reaction to stock price drops, but no reaction to increasing stock prices. The present paper studies the effects of such a policy in a DSGE model. The asymmetric policy rule introduces an important non-linearity into the model: Booms in output and inflation tend to be amplified, while recessions are dampened. Moreover, such a policy gives rise to expectations-driven booms in asset prices. We further investigate to what extent an asymmetric stock price reaction could be motivated by the desire of policymakers to correct for inherent asymmetries in the way stock price movements affect the macroeconomy.