Financial market segmentation, stock market volatility and the role of monetary policy

Author-Highlights•We study optimal monetary policy in a model with segmented stock market.•Only stock market participants bear financial income risk (versus non-participants).•Optimal monetary policy tightens in good and expands in bad times for the financial markets.•A 2% inflation targeting policy induces welfare losses.•Optimal monetary policy does not attempt to minimize stock price volatility.

We study a segmented financial markets model where only the agents who trade stocks encounter financial income risk. In such an economy, the welfare-maximizing monetary policy attains the novel role of redistributing the traders' financial market risk among all agents in the economy. In order to do that, optimal monetary policy reacts to financial market movements; it is expansionary in bad times for the financial markets and contractionary in good ones. In our quantitative exercise, a dividend shock generates different policy responses and consumption paths among the optimal and the 2% inflation targeting policy. The latter implies large distributional welfare losses and risk sharing losses of similar magnitude with those generated by business cycle fluctuations. In addition, the optimal monetary policy does not minimize stock price volatility and implies lower inflation volatility than other commonly used policies.