Monetary Policy and Stock Market Booms

Historical data and model simulations support the following conclusion. Inflation is low during stock market booms, so that an interest rate rule that is too narrowly focused on inflation destabilizes asset markets and the broader economy. Adjustments to the interest rate rule can remove this source of welfare-reducing instability. For example, allowing an independent role for credit growth (beyond its role in constructing the inflation forecast) would reduce the volatility of output and asset prices.

Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

High-interest-rate currencies tend to appreciate in the future relative to low-interest-rate currencies instead of depreciating as uncovered-interest-parity (UIP) predicts. I construct a model of exchange-rate determination in which ambiguity-averse agents face a dynamic filtering problem featuring signals of uncertain precision. Solving a max-min problem, agents act upon a worst-case signal precision and systematically underestimate the hidden state that controls payoffs. Thus, on average, agents next periods perceive positive innovations, which generates an upward re-evaluation of the strategy's profitability and implies ex-post departures from UIP. The model also produces predictable expectational errors, ex-post profitability and negative skewness of currency speculation payoffs.uncovered interest rate parity, carry trade, ambiguity aversion, robust filtering

Ambiguity Aversion: implications for Uncovered Interest Rate Parity Puzzle

A positive domestic-foreign interest rate differential predicts that the domestic currency will appreciate in the future. So, on average, positive profits can be made by borrowing in low-interestrate currencies and lending in high-interest-rate currencies (a strategy known as the ‘carry trade’). Standard theory implies that capital inflows into high-interest-rate currencies should be so large that the positive profits from the carry trade are wiped out. The absence of inflows of such a magnitude is one way to characterize the well-known uncovered interest rate parity (UIP) puzzle. A standard, though controversial, resolution of the puzzle is that what limits capital inflows when domestic interest rates are high is an objective increase in risk in the domestic currency. This explanation has been challenged on the grounds that it is difficult to empirically detect this risk. The alternative explanation I pursue is that agent’s beliefs are systematically distorted. This perspective receives some support from an extended empirical literature using survey data. I construct a model of exchange rate determination in which agents ’ distorted beliefs are derived formally from the assumption that they are ambiguity averse. In my model, agents do not know key parameters of the stochastic process driving the variables they forecast. In the presence of parameter uncertainty, ambiguity-averse agents compute forecast

Monetary Policy and Stock Market Booms

Historical data and model simulations support the following conclusion. Inflation is low during stock market booms, so that an interest rate rule that is too narrowly focused on inflation destabilizes asset markets and the broader economy. Adjustments to the interest rate rule can remove this source of welfare-reducing instability. For example, allowing an independent role for credit growth (beyond its role in constructing the inflation forecast) would reduce the volatility of output and asset prices.inflation targeting, sticky prices, sticky wages, stock price boom, DSGE model, New Keynesian model, news, interest rate rule.