Monetary policy, doubts and asset prices

Asset prices and the equity premium might reflect doubts and pessimism. Introducing these features in an otherwise standard New-Keynesian model changes optimal policy in a substantial way. There are three main results: (i) asset-price movements improve the inflation-output trade-off so that average output can rise without much inflation costs; (ii) a “paternalistic” policymaker - maximizing the expected utility of the consumers under the true probability distribution - chooses a more accommodating policy towards productivity shocks and inflates the equity premium; (iii) a “benevolent” policymaker - maximizing the objective through which decisionmakers act in their ambiguous world - follows a policy of price stability.