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Anastasia S. Zervou

Department of Economics, Texas A&M University, College Station, TX 77843 November 11, 2011

Abstract We explore the role of monetary policy in a world of segmented nancial markets, where only the agents who trade stocks encounter nancial income risk. In such an economy, the welfare maximizing monetary policy attains the novel role of sharing the nancial market risk traders face, among all agents in the economy. In order to do that, monetary policy reacts to nancial market advances; it optimally expands in bad times for the nancial markets and optimally tightens in good ones. In addition, our model suggests that optimal monetary policy is not concerned with stock price changes, does not necessarily minimize stock price volatility, and the policy that does, involves welfare losses. It is though concerned, to some extent, with ination stability. JEL classication: E44; E52; G12. Keywords: Limited Participation, Optimal Monetary Policy, Financial Risk Sharing, Stock Price Volatility.

Texas A&M University, 4228 TAMU, College Station, TX 77843, azervou@econmail.tamu.edu, http://econweb.tamu.edu/azervou/. I am very grateful to Stephen Williamson and to Costas Azariadis and James Bullard for their constructive comments. I also thank Jacek Suda, the entire Macro Reading Group at Washington University, seminar participants at Athens University of Economics and Business, Bank of Cyprus, University of Cyprus, University of Piraeus, Rice University and participants of the 2008 Missouri Economics Conference, 12th ZEI International Summer School on Monetary Macroeconomics, 7th Conference on Research on Economic Theory & Econometrics, 2009 North American Summer Meeting of the Econometric Society, 2009 European Meeting of the Econometric Society and 2010 Midwest Macro Meetings for helpful comments. I thank Yulei Peng for excellent research assistance. Finally, I thank the Olin Business Schools Center for Research in Economics and Strategy (CRES) for funding.

Introduction

Should nancial market developments be a matter of monetary policy? This is a widespread concern among central bankers, especially aggravated by the recent 2007-2009 recession. The Federal Reserve and central banks of other developed countries seem to follow expansionary policies in response to nancial markets distress.1 Previous literature regarding how a monetary authority should respond to asset market advances focuses on policy responses to asset prices changes (e.g., Bernanke and Gertler, 2000; Bernanke and Gertler, 2001; Cecchetti et al., 2001; Gilchrist and Leahy, 2002 for a review on the topic; Faia and Monacelli, 2007). This paper studies some new aspects of the interaction of the monetary authority with the stock market. Specically, it develops a cash-in-advance model and studies the risk-sharing implications of an optimal, welfare maximizing monetary policy in the presence of segmented nancial markets. In addition, it addresses the question of whether the optimal policy entails lower fundamentals originated stock price volatility when compared with other, widely used, monetary policy rules. We nd that this is not necessarily the case. Financial market segmentation is well documented (Mankiw and Zeldes, 1991; Guiso et al., 2002; Vissing-Jrgensen, 2002) and previously used in monetary models as an apparatus for studying the liquidity eect (Alvarez et al., 2001), forms of non-neutrality of money (Williamson, 2005; Williamson, 2006) and a positive ination target (Antinol et al., 2001).2 Our model is based on two implications of nancial market segmentation. First, as previous literature points out (Grossman and Weiss, 1983; Rotemberg, 1984; Lucas, 1990; Fuerst, 1992; Alvarez et al., 2001; Williamson, 2005; Williamson, 2006), monetary policys actions diuse in the economy through the nancial system, aecting those connected to the nancial system and those who are not in a dierent manner. During open market operations the Federal Reserve interacts with large nancial institutions, directly aecting nancial market participants; yet only indirectly aecting non-participants, through price adjustments. For example, a monetary expansion benets those who are at the receiving

1 E.g., the Federal Reserve has been consistently decreasing the federal funds rate for almost all meetings from August 2007 until the end 2008, after which the target was too low to further decrease. See Bernanke (2009). Also, the marginal lending facility of the European Central Bank has been consistently decreasing through 2008-2009. 2 For its empirical importance see Landon-Lane and Occhino (2008) and Mizrach and Occhino (2008).

end of the expansion; however, it increases prices and hurts those who are not connected to the nancial system. Thus, monetary policy has distributional eects.3,4 Second, segmentation implies that only a fraction of the population is connected to the nancial system, so that only a fraction of the population is subject to nancial income risk. Although agents heterogeneity with respect to their connection to the nancial markets has been addressed in previous models (Grossman and Weiss, 1983; Rotemberg, 1984; Lucas, 1990; Fuerst, 1992; Alvarez et al., 2001; Williamson, 2005; Williamson, 2006), agents heterogeneity in terms of their nancial risk holding has not been yet explored and introduces additional considerations for monetary policy. Specically, these distributional eects that monetary policy exhibits under stock market segmentation aect the way nancial income risk is shared between nancial market participants and non-participants. This happens automatically, through monetary policys usual operation. Our model studies how a monetary authority that cares equally about every agent, connected or not to the nancial markets, can perfectly share the nancial risk among all agents in the economy, maximizing in this way total welfare. Financial markets distress translates into lower dividend income; monetary policy optimally expands and benets nancial market participants. However, expansionary policy increases the price of the consumption good, decreasing the consumption of those who do not participate in the nancial markets. By contrast, monetary policy optimally tightens whenever nancial markets ourish and dividend income is higher than expected. Such a reaction reduces the consumption of the nancial market participants, but also makes the consumption good more aordable, increasing the consumption of non-participants. Answering the question asked above, whether and how monetary policy should respond to stock market advances, this paper suggests that monetary policy optimally expands in bad times for the nancial markets and tightens in good ones. This result assigns to monetary policy the novel role of sharing risk between heterogeneous agents of a particular type: nancial market

Early work on the distributional eects of monetary policy involves models that are not very tractable (Grossman and Weiss, 1983; Rotemberg, 1984), although important attempts to obtain tractability resulted, contrary to this paper, in models that suggest limited role for monetary policy (Lucas, 1990; Fuerst, 1992). 4 There is of course large literature exploring the distributional eects of ination (Erosa and Ventura, 2002; Doepke and Schneider, 2006). In addition, recent work studies monetary policy regimes and the distributional eects that the resulted ination has (Meh et al., 2010). However, here we are exploring direct distribution eects that monetary policy exerts.

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participants and non-participants. We further investigate the role of monetary policy in our model and compute stock price volatility and ination volatility implied by the optimal monetary policy rule; we compare these volatilities with those implied by the constant money supply, ination targeting and nominal interest rate peg policy rules. There is vast nance literature related to one or more of this models elements, studying stock price volatility (Allen and Gale, 1994; Guo, 2004; Guvenen and Kuruscu, 2006; Chien et al., 2011). We abstract from other issues this literature has considered (e.g., endogenous participation, idiosyncratic shocks or heterogeneous preferences), in order to focus on the importance of monetary policy regimes in generating stock price volatility. We nd that the optimal monetary policy does not necessarily produce lower stock price volatility compared to the other policy rules and thus, stock price changes should not be an integral part of monetary policy. Furthermore, the policy that minimizes stock price volatility also reduces welfare. In addition, our ndings suggest that monetary policy targeting ination does not take care of stock price volatility, in contrast to previous literature that does not account for nancial market segmentation (Bernanke and Gertler, 2000; Bernanke and Gertler, 2001). Optimal monetary policy does however care, to some extent, about keeping ination stable; it produces half the ination volatility that the constant money supply policy does. Also, contrary to previous literature (Allen and Gale, 1994) high nancial market participation does not necessarily associate with low stock price volatility. This is because in our model, stock price volatility depends on the type of policy rule the monetary authority follows. Recent work attempts to specify optimal monetary policy in limited participation New Keynesian models.5 Bilbiie (2008) focuses on assigning relative weights on output and ination in an interest rate Taylor-type rule, and Andres et al. (2010) focuses on addressing trade-os between monetary authoritys stabilization goals. We use a very dierent model to focus on the risk sharing role of optimal monetary policy and address the issue of how stock price volatility is aected by monetary policy. Overall, this paper suggests that in the presence of segmented nancial markets monRelated topics have also been studied using full participation models, e.g., Challe and Giannitsarou (2011) develops a full participation asset pricing New Keynesian model in order to match the empirical ndings of the stock price response to monetary policy shocks (Rigobon and Sack, 2004; Bernanke and Kuttner, 2005).

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etary policy should react to nancial market advances through channels that previous literature has ignored. Monetary policy attains the role of sharing nancial income risk between nancial market participants and non-participants. This policy is, to some extent concerned with ination stability, but is not concerned with stock price volatility. The rest of the paper is organized as follows. Section 2 introduces the model economy and studies the competitive equilibrium and asset pricing. Section 3 describes the implications and role of the optimal monetary policy rule. Section 4 examines the stock price and ination volatility for various policy rules. Section 5 concludes.

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2.1

Environment

The model economy consists of the goods market and three asset markets: nominal bond, stock and money market. The bond and stock markets are segmented, so that from a continuum of innitely lived households of measure one, only (0, 1) fraction participates in these markets although 1 does not. The stock market is introduced in a way similar to the Lucas (1978) model, i.e., participating agents receive a share of the stochastic dividend tree in proportion to the quantity of shares they hold. The bonds are introduced for examining the asset pricing of the model. All agents have identical preferences and seek to maximize:

E0

t=0

t u(ci ), t

where is the discount factor with 0 < < 1 and ci 0 denotes consumption at time t t by consumer of type i, with i {T, N }. Consumers types T and N are described below. We assume that u (.) > 0 and u (.) < 0. The fraction 1 of the population that does not participate in the nancial markets, or the non-traders (i = N ), receives every period a xed real endowment y N > 0 of the non-storable consumption good. The fraction of the population that participates in the nancial markets, or the traders (i = T ), receives every period a xed real endowment y T > 0 and a share of the stochastic real total dividend t . We assume that there is a rm 5

which receives endowment t in period t and distributes it as dividends to its share holders. The total dividend t is random, has mean > 0 and is described as follows: t = + t , (1)

2 where t is an iid shock with mean zero, variance and support [, ). The stochastic

dividend is distributed among traders proportionally to the quantity of shares they bought. Consequently, traders have a risky component in their income, although non-traders collect only the xed endowment y N . Total income in this economy equals yt , yt t + y T + (1 )y N , and thus mean income is given by: y = + y T + (1 )y N . (2)

In order for total output to be independent from the nancial market participation rate , we let the mean income of the traders equal that of the non-traders, i.e., y T +

= yN .

Besides traders having a risky component in their income (although non-traders do not), there is one more dierence between nancial market participants and non-participants. That is, nancial market participants are directly aected by monetary policys actions. As is typical in the limited participation literature (Grossman and Weiss, 1983; Rotemberg, 1984; Lucas, 1990; Fuerst, 1992; Alvarez et al., 2001; Williamson, 2005; Williamson, 2006), this model reects the fact that initially, open market operations aect only the nancial sector of the economy. We employ this feature by having the monetary authority distributing transfers t only to the traders, although the non-trades do not collect such transfers.6 The timing of the model is as follows. Agents enter period t with money balances mi 0 for type i {T, N }. At the beginning of the period the dividend shock t is t realized, although given the cash-in-advance assumption, is not available to the traders until the end of the period. The nancial markets open rst (while the goods market remains closed) and the monetary transfer is distributed to the traders. In period t traders can sell the zt amount of stock they bought in period t 1 and buy new stock at price

The cash provision to traders through this practice is equivalent to open market operations, which in fact aects directly only the nancial market participants.

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qt . Bonds bought in period t 1 at price st1 < 1 expire and pay one unit of money in period t. Using their money holdings mT , the money from selling zt stocks, the returns t from holding bt bonds and the monetary transfer t , traders can decide their new stocks and bonds purchases, zt+1 and bt+1 . After the nancial markets close, the goods market opens. In order for money to have value we assume that no agent consumes her own endowment and dividends but needs cash to nance consumption. Each household consist of a shopper-seller pair. The shopper receives the cash remaining after the transactions in the nancial markets complete and buys consumption good from other agents. The seller sells at price pt > 0 the real endowment y T and share zt+1 of the real dividend t , if she is a trader, or just real endowment y N , if she is a non-trader. After the operations in the goods market conclude the seller and the shopper meet again, consume the consumption good the shopper purchased and keep the cash the seller received as money holdings for next period. That is, consumption is subject to the following cash-in-advance constraints, for traders and non-traders respectively: mT + qt zt + bt + t pt cT + qt zt+1 + st bt+1 , t t mN pt cN . t t (3) (4)

The budget constraints for the traders and non-traders are given by equations (5) and (6) respectively: mT + qt zt + bt + t + pt zt+1 t + pt y T mT + pt cT + qt zt+1 + st bt+1 , t t+1 t (5)

where zt+1 t is the real dividend payment distributed in period t (but available to use in period t + 1). mN + pt y N mN + pt cN . t t+1 t (6)

The monetary authority operates by setting the money growth each period t. Whenever money supply increases, the extra cash is distributed as transfers to the traders although

whenever money supply decreases, traders are taxed. Mt = t + Mt1 or equivalently, Mt = Mt1 (1 + t ), (7)

where t [1, ) denotes money growth rate from time t 1 to time t and Mt denotes money stock in period t, with a non-negative initial value. The extra money supplied at time t is distributed as transfers to the traders.

2.2

We now explore the models equilibrium and asset pricing. In equilibrium the four markets operating in this economy clear. The real total endowment and dividend is consumed by traders and non-traders: t + y T + (1 )y N = cT + (1 )cN . t t Using equation (2), which denes mean income, the goods market clearing condition becomes: y + t = cT + (1 )cN . t t Traders hold all shares of the rm and the stock market clears: zt+1 = 1 zt+1 = The bond market clears too: bt = 0. Finally, the money market clears: mT + (1 )mN = Mt , t+1 t+1 where Mt is given by equation (7). The maximization problem of each household is subject to constraints (3) and (5) for the traders, and (4) and (6) for the non-traders. Because the nancial markets operate 8 (11) (10) 1 . (9) (8)

before the goods market does, holding money after the nancial markets close bears positive opportunity cost when the return on bonds or stocks is positive. Only the amount of money required for purchasing the desired amount of consumption good is held and the equilibrium is constructed for binding cash-in-advance constraints. Later we examine conditions which guarantee that traders cash-in-advance constraint binds. The budget constraints also bind, as usual. The implications for the budget constraints are: pt zt+1 t + pt y T = mT , t+1 for traders, and p t y N = mN , t+1 (13) (12)

for non-traders. The above equations reveal that the cash balances with which the agents begin period t + 1 match the fraction of their wealth that the cash-in-advance constraints prevented them from using in period t. These are, the proceeds from selling in the goods market the real endowments, and for the case of traders, the real dividends distributed in period t. Furthermore, from the goods, stock, bond and money market clearing conditions, (8), (9), (10), (11) respectively, the cash-in-advance constraints (3) and (4) holding with equality and the money supply equation (7), we get a version of the quantity equation where velocity equals one, and total output equals the sum of the deterministic part, y T + (1 )y N = y , and the stochastic part, t : pt = Mt . y + t (14)

Equilibrium consumption for the two groups of agents is derived as follows. Combining the non-traders binding cash-in-advance constraint (4) with equation (13) and the goods price (14) we nd that the non-traders consumption is given as follows: cN = t pt1 y + t 1 y=y . pt y + t1 1 + t (15)

The above equation together with the market clearing condition for the goods market,

given by equation (8), imply that the traders consumption can be written as follows:

cT = t pt1 1 t y + t (t1 )(1 + t ) + y ( + t ) ( + (t1 )) + y = . pt pt ( + t1 )(1 + t ) y

(16)

Equations (15) and (16) reveal the distributional eects that monetary policy exhibits in this segmented nancial markets model7 : Monetary policy aects indirectly, through prices, all agents in the economy; however, it aects directly, through transfers or taxes, only the nancial market participants. In an expansion, monetary policy creates an ination tax for all households, but distributes monetary transfers only to the traders; traders consumption increases and non-traders consumption decreases. In contrast, in a tightening, consumption becomes cheaper for both types of agents; however, only the traders get taxed and thus their consumption shrinks, although non-traders consumption rises. Note also that monetary policy aects risk sharing between traders and non traders. Any monetary policy rule that reacts to real activity aects the risk sharing between the two groups of agents. In the next section we study how monetary policy can share this risk optimally. Also, notice how, in the case of limited participation, dividend income aects the consumption of the two groups, assuming that monetary policy does not react to such a shock. The equilibrium consumption equations reveal that an increase in the current total dividends distributed, t , implies lower price for the consumption good in period t, increasing consumption for both traders and non-traders. On the other hand, an increase in total real dividends distributed the previous period, t1 , decreases the price of the consumption good in period t 1 and thus the value of the consumption good carried in the form of money balances from period t 1 to period t. For iid dividend shocks, consumption in period t decreases for the non-participants although increases for the participants. The increase in traders consumption depends on the participation rate; the more participating agents there are, the smaller the share of the t1 shock each of them receives is. Therefore, the increase in traders consumption is negatively aected by the participation rate. Finally, it is important to notice that because of the cash-in-advance constraint, the dividend t is currently distributed but is not currently consumed. It is the previous period dividend

Market segmentation allows for monetary policys distributional eects, which are not present under full nancial market participation

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10

t1 that is consumed in period t. While the above analysis did not require solving the maximization problem, the study of asset prices requires such a procedure. In particular the traders utility maximization problem needs to be solved, subject to the cash-in-advance constraints (3), (4) and budget constraints (5), (6). The rst order conditions imply that the price of the bond is determined as follows: Et u (cT ) u (cT ) t+1 t = st . pt+1 pt (17)

Equation (17) describes the usual pricing of nominal bonds: the utility increments traders expect to receive in period t + 1, when the bond matures and pays back, equals the foregone utility they suer from buying the nominal bond in period t. In addition, this equation reveals a Fisher eect, so the nominal interest rate is given by the real interest rate, augmented by an expected ination premium. Note also that a strictly positive multiplier associated with the traders cash-in-advance constraint (3), implies that st < 1, so the nominal interest rate is strictly positive. For the case of certainty the usual condition is required to satisfy this assumption, i.e., that money growth must be greater than the discount factor. The rst order conditions imply the following expression for the stock price: Et u (cT ) u (cT ) t+1 t (qt+1 + pt t ) = qt , pt+1 pt (18)

which evaluates that the discounted marginal utility expected in period t + 1, when the dividends are paid and the share can be traded again, equals the forgone utility incurred from purchasing the share at time t. We will return to the stock price and its volatility later, when we will apply various policy specication in equation (18) and compare across them.

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In this section we study a new role for intermediation that optimal monetary policy acquires in our model. We consider a monetary authority that maximizes total welfare by choosing the money supply growth rate. We assume that monetary authority assigns equal weight to each agent, no matter to which group the agent belongs to. Then, weight is assigned to the group of traders and 1 to the group of non-traders. The maximization problem is as follows:

max E0

t t=0

The rst order conditions imply the following: u (cT ) t cT cN t + (1 ) u (cN ) t = 0. t t t (19)

From equations (15) and (16) which determine consumption in equilibrium, we can calculate the derivative of consumption with respect to money growth: cN y + (t ) y t = , t y + (t1 ) (1 + t )2 and cT 1 y + (t ) y t = . t y + (t1 ) (1 + t )2 Note that non-traders consumption decreases although traders consumption increases whenever monetary policy expands. This is because limited participation prevents the monetary authority from directing its transfers to all agents, but distributes them instead only among the agents who participate in the nancial markets. Expansionary monetary policy increases current goods price aecting negatively all agents; the traders however, receive the monetary transfer and the positive eect is stronger. Notice also that the higher the nancial market participation rate , the smaller the fraction of the monetary expansion each trader receives. Substituting the above equations into equation (19) we nd that optimal money growth

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The above expression reveals a new role for monetary policy, which is to share the nancial income risk that traders are exposed to, among all agents in the economy. When the total real dividend is low (lower than the total mean dividend ) traders consump tion decreases. Optimal monetary policy expands and increases traders consumption by distributing to them higher transfers. As monetary policy expands current goods price increases, reducing non-traders consumption. In contrast, whenever the total dividend is high (higher than the total mean dividend ), traders consumption is high. Optimal mon etary policy tightens by taxing traders; the goods price decreases causing the non-traders consumption to rise. Financial income risk is perfectly shared between nancial market participants and non-participants, through optimal monetary policy.8 Financial market segmentation exposes only participants to nancial income risk. In addition, it allows monetary policy to have distributional eects and the power to undo this market failure,9 and share the dividend risk among all agents. Note that because of the cash-in-advance constraint, traders at time t consume the dividend of the previous periods, t1 . The only relevant eect of t in period t is through price changes, which aect both types of agents. Then, optimal policy at time t chooses to react to total dividend distributed at time t 1, because t1 is the source of dierential eects across the two groups, i.e., positive eects for traders and negative for non-traders.10 As a result, this model suggests that optimal monetary policy responds to advances in the asset markets, however not in the way previous research have considered (e.g., Bernanke and Gertler, 2000; Bernanke and Gertler, 2001; Cecchetti et al., 2001; Gilchrist and Leahy, 2002; Faia and Monacelli, 2007). Here the monetary authority responds to real dividend

Modifying the model so the monetary authority to have intertemporal considerations would not make the Friedman rule optimal. This is because monetary authority has distributional considerations in this model. This is similarly to Williamson (2005). 9 We consider the case that limited participation is generated through entry, information, trading costs etc. Vissing-Jrgensen (2003) nds that these costs are very important for explaining nancial market segmentation 10 Following the standard CIA assumption and timing of Lucas (1982), we only allow cash to be used for consumption purchases. We have explored a version of the model where agents are allowed to use current real dividends for nancing current consumption. Then, optimal monetary policy reacts to current real dividends in the exact same way that reacts to lagged real dividends in equation (20).

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13

changes in order to redistribute wealth from the privileged nancial market participants who were fortunate to encounter good nancial markets conditions, to the rest of the population, or, from the rest of the population to the disadvantaged nancial market participants who were hit by bad nancial markets shocks. The above result holds for any concave utility function. In addition, it is not sensitive to the xed endowment assumption. In the case of random mean endowments y , optimal monetary policy would still share between the two types of agents the extra risk that participants hold, and increase in this way total welfare. Also note that in this model optimal monetary policy reacts to real shocks, without the assumption of price rigidities. This is because of redistribution concerns, similarly to Williamson (2005). In our paper we take limited participation as given and ignore the interesting complications that the participation decision would introduce in the model.11 If participation cost, e.g., entry cost, trading cost or lack of information, discourages a positive mass of agents to participate in the nancial markets, then nancial markets are segmented and our model suggests that monetary policy bears real eects. If the monetary authority follows the optimal rule, the consumption of traders and non traders each period is given below: cN = cT = Yt = y + t . t t (21)

We see that optimal monetary policy shares perfectly the risk between the two groups. In addition, although we are using an exogenous participation framework, optimal monetary policy makes agents indierent between participating in the nancial markets or not. Precisely, the traders would vote for any policy with t > as such a policy would int crease their consumption relative to what they consume under the optimal monetary policy regime. On the contrary, the non-traders would vote for any policy with t < for the t same reason. Optimal monetary policy equates consumption of the two groups and makes agents indierent between participating or not in the nancial markets. Finally, note that contrary to Bilbiie (2008), the optimal monetary policy in this model

Alvarez et al. (2002) and Khan and Thomas (2007) have thoroughly examined cases of endogenous participation.

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does not depend on the participation rate. This is true because monetary authority has direct eects on the same group of agents that faces the dividends risk. It is the traders group that is exposed to nancial income risk; the same group is directly aected by monetary policy. However, for monetary policy to have any real eect, the limited participation assumption is necessary. Hence, as soon as nancial markets are segmented, no matter to what extent, monetary policy can operate in such a way that everybody shares and consumes the total output and becomes indierent between participating or not in the nancial markets. Our model implies that monetary policy aects the risk sharing between nancial market participants and non-participants automatically, through its usual function. We suggest that policy makers should consider the direction of responses the model proposes in order for the redistribution from one group of agents to another be welfare improving. Of course this does not mean that monetary policy does not have other considerations, which our parsimonious model has intentionally ignored in order to focus on this new one, the nancial income risk sharing. In addition, we suggest that monetary policy is the relevant policy to consider for sharing nancial income risk. As previously suggested (e.g., Taylor, 2000), monetary policy does not require special design of tax scheme and takes less time and resources to implement than scal policy. In our case, monetary policy aects nancial income risk sharing automatically, through its usual operation, taking no extra time or resources to implement.

Given that previous literature on monetary policys response to nancial market advances has been focused on exploring whether or not monetary authority should consider assets price changes in deciding its instruments (e.g., Bernanke and Gertler, 2000, 2001; Cecchetti et al., 2001; Gilchrist and Leahy, 2002; Faia and Monacelli, 2007), we study the implications for stock price volatility that monetary policy has in our model. In additions, we study monetary policys implications for ination volatility. In Section 4.1 we compute the stock price volatility for four policy rules: optimal, constant money supply, ination targeting and nominal interest rate pegging. We ask 15

the question whether optimal monetary policy implies lower stock price volatility when compared to the other, frequently cited policy rules, and we nd that this is not necessarily the case. Section 4.2 examines the ination volatility that the above monetary policy rules produce. We nd that optimal monetary policy is to some extent concerned with ination volatility, but does not coincide with the policy that minimizes ination volatility. In addition, we derive the policy rule associated with minimal stock price volatility and compute the welfare loss caused by implementing that policy instead of the optimal one. The analysis suggests that the welfare maximizing monetary policy does not attempt to minimize stock price volatility, and thus, stock price changes should not be an integral part of monetary policy. This analysis, however, does not suggest that monetary policy should not react to advances in the stock market. On the contrary, as analyzed in Section 3, optimal monetary policy reacts to dividend shocks by tightening in good times for the nancial markets and expanding in bad, in order to perfectly share nancial income risk. For convenience, we have summarized and discussed our main conclusions from this section, so the reader may refer directly to Section 4.3.

4.1

For the analysis that follows we need to specify a utility representation in order to compute explicitly the stock price and its variance. We use the logarithmic utility function.12 We rst calculate the real stock price, qt =

qt pt ,

assuming that there are no bubbles so that the transversality condition holds, is as follows:

q t = Et

j=1

That is, we can write the stock price as the expected discounted value of all future dividends. After substituting the expressions for the goods price (14) and traders consumption (16), we nd the following expression for the stock price:

q t = Et

j=1

12

(22)

Similar conclusions are reached for a constant relative risk aversion function.

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In the examples that follow we compute the variance of the stock price for a choice of policy rules and compare the results. We rst compute the stock price under the assumption that monetary policy is conducted optimally, following the optimal rule (20). We linearize around the dividend mean value, = ( y T ), and nd the unconditional variance of the stock price for the optimal y monetary policy rule: Var(t ) = q

2 2 [(1 ) + ( y T )]2 , y y (1 )2 y 2

(23)

A positive shock in current dividends under the optimal monetary policy rule would make traders want to acquire more shares, increasing the stock price. Higher dividend volatility in (23) translates into higher stock price volatility. Furthermore, under optimal monetary policy agents consumption equals aggregate output, which is not aected by the nancial markets participation rate (see equation (21)). However, higher participation increases the mean total dividend, which in turns positively aects the stock price and its variance. We now compare the volatility produced by the optimal monetary policy rule with that produced by the zero money growth rule. To compute the latter, we substitute t = 0 for every period, in the real stock price equation (22) and linearize around the iid dividend shocks. Stock price volatility for a monetary authority that does not change its money supply is: Var(t ) = q =0

2 2 {(1 )2 ( y T )2 + [( y T ) + (1 )y T ]2 }. y y (1 )2 y 2

(24)

Higher dividend volatility translates into higher stock price volatility. However, the eect of the nancial market segmentation on the stock price and its variance are ambiguous and depend on the parameter values. Comparing equations (23) and (24) is not straightforward. To illustrate that optimal monetary policy is not necessarily associated with low stock price volatility we use the following example (for convenience, we summarize the parameter values in Table 1). For

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Parameter Mean income Traders endowment Total dividend variation Discount factor

Symbol y yT

y = 1, y T = 0.9, = 0.9 and = 0.06, Figure 1 shows that there is a critical value for the participation rate below which optimal monetary policy produces less volatility than the constant money supply policy, and above which optimal monetary policy generates higher volatility.13 For a nancial market participation rate of = 0.35 it is true that the optimal monetary policy implies lower stock price volatility than the constant money supply policy; however, this result reverses as the nancial market participation increases.14 We now explore the ination targeting policy and its implications for stock price volatility. Ination for any monetary policy rule t is given below: t = pt pt1 ( + t1 )(1 + t ) y = 1, pt1 y + t (25)

and for ination target t = the corresponding monetary policy action is:

1 + = (1 + ) t

y + t . y + t1

(26)

This equation implies that whenever current dividends are low compared to the previous period, inationary pressure increases. A monetary authority aiming in attaining its ination target reduces money supply and reduces ination back to its target level. To derive the stock price variance for the ination targeting monetary policy rule, we

linearize the real stock price (22) for this policy t = , around the mean of the iid t

13

= 0.06 is between Shiller (1981)s estimates of 0.01481 and 0.09828, based on two dierent data

sets.

14 = 35% is approximately the percentage of the US population that Vissing-Jrgensen (2002) classies as bondholders.

18

Stock Price Variance 0.012 0.01 0.008 0.006 0.004 0.002 0.2 0.4 0.6 0.8 1

Figure 1: Stock price volatility of optimal (large-dashed line), constant money supply (solid line), = 2 2 percent ination targeting (small-dashed line) and nominal interest rate peg at r + 1 = (thick line) policy rules, for the parameter values given in Table 1.

Var(t ) = q 2 2 [(1 + )( y T ) + (1 )( + )]2 y y . (1 )2 y 2 ( + )2 (1 + )2

(27)

An increase in the variance of the dividend shock increases the volatility of the stock price. The eect of the degree of segmentation is not clear though, as it has ambiguous eects on consumption under this policy rule. Given the specic ination target that the monetary authority chooses, we can compare the stock price volatility that the ination targeting policy produces with that of the optimal and constant money supply policies. For example, compared to the optimal policy, a zero ination targeting policy produces always higher stock price volatility. This is because of limited nancial market participation, although under full participation these two polices generate the same amount of stock price variance. As a second example we consider the policy implied by setting ination target equal to = 2 percent. We use the same parameter values as before, summarized in Table 1. We see in Figure 1 that choosing the policy that produces the least stock price variability depends crucially on the nancial market participation rate and on the other parameter values.

19

Another example of policy rule we consider is that of the nominal interest rate peg. By substituting in the equation for bonds price (17), the equilibrium price level (14), and traders consumption (16), the bond price becomes: s t = Et y + t (t1 )(1 + t ) + y ( + t ) . ( + t1 )(1 + t ) (t )(1 + t+1 ) + y ( + t+1 ) y

Linearizing the expression inside the expectation around t+1 = t = = 0 and t = t1 = , and assuming that all shocks are iid and uncorrelated to each other, the nominal interest rate, 1 + rt = 1 + rt =

1 st1 ,

equals:

Before we explore the stock price implications of the nominal interest rate peg policy, we rst examine the liquidity eect of the model. Dierentiating the above expression with respect to current money growth we see that

rt t1

becomes zero when there is full participation in the nancial markets, signifying the liquidity eect. As in Alvarez et al. (2001), full participation implies that the only way monetary policy aects the nominal interest rate is through expected ination, i.e.,

rt Et1 t

> 0.

We compute the money supply policy implied by pegging the nominal interest rate at level r + 1 =

1 (1) ,

mean values of the shocks, i.e., t1 = t = Et1 (t ) = and t2 = t1 = . Equating the nominal interest rate target r to equation (28) we nd the monetary policy rule that pegs the nominal interest rate at level r :

1 + r = (1 + ) + t

t t1 . y

(29)

The above equation reveals that whenever the dividend shock consumed in the current period is high, i.e., t1 = t1 > 0, traders are prompt to buy more assets and the price of the bond rises. A monetary authority that aims keeping the nominal interest rate at a specic level would then tight and bring the nominal interest rate back to its target. In addition, whenever t = t > 0, future consumption is expected to rise; traders tend to

20

buy fewer assets during the current period, forcing the price of the bond to fall. In order to keep the nominal interest rate at its target, monetary authority reacts by increasing money supply. Linearizing as usual around = ( y T ) and assuming iid dividend shocks we nd y

the stock price variance for the interest rate pegging policy, = r , using the real stock

2 2 (1 )2 ( y T )2 2 2 y 2 y2 2 (1 + )4 (1 ) ( + )

Var(t ) = qr

(30)

{( y T )[1 + + (1 + )] + (1 )( + )(1 + )}2 y y + . 2 (1 + )4 ( + ) The monetary authoritys choice of interest rate peg, combined with the parameters values will determine whether or not this policy creates higher stock price volatility than the other policies considered. We rst examine the example of pegging the equilibrium rate, r =

1 ,

derived by setting = 0. It turns out that the stock price variance when

pegging the equilibrium rate is equal to this produced by targeting zero ination, i.e.,

Var(t ) = Var(t =0 ), which in turn is higher than the stock price variance produced under qr q

2 As a second example we consider a monetary authority which pegs a rate of r + 1 = .

Using for the rest of the parameters the same values as before, summarized in Table 1, we see in Figure 1 that depending on the parameter values, a dierent policy produces the least stock price volatility. Overall, in our model, it is not the case that the optimal monetary policy is in general associated with minimal stock price volatility. We also derive the policy rule that a monetary authority interested in minimizing stock price volatility would implement. Then we calculate the welfare loss that this policy produces compared to the optimal policy. We consider a central bank that reacts to the distributed dividends in the previous and current

period, t1 and t . Specically, we derive a linear function f (.), where f (t1 , t ) = q , t and q is the money growth associated with minimal stock price volatility. t

We substitute in equation (22) the monetary rule associated with minimum stock price

volatility, t = q . Then, we linearize around the mean total dividend and nd the lint

21

earized expression for the stock price, as given below: 1 + f () + y f1 () + (1 ) t1 (1 )[1 + f ()] (1 )[ + f ()][1 + f ()]2 y [ + f ()][1 + f ()] + (1 )f2 () y y [ + f ()] [1 + f ()] y f1 () + (1 )[ + f ()][1 + f ()]2 y y [ + f ()][1 + f ()] t ,

qt q

where f () is the money growth rate when the dividend shocks t1 , t equal to their mean, and f1 (), f2 () are its rst derivatives with respect to the rst and second argument respectively, evaluated at the mean of the dividends shocks. Also, t is dened in equation (1). Letting the above expression be invariant, and by assuming that mean money growth is zero, we can nd the slope of the money growth function that minimizes stock price volatility, with respect to the two dividend shocks: f1 () = 1 [ + (1 )] y and f2 () = . y (1 )y

We consider the case of a linear monetary policy rule, which is as follows: 1 [ + (1 )] y 1 + q = 1 (t1 ) (t ). t y (1 )y We compare this policy to the optimal one, in terms of total welfare:

W q W = E0 t=0 q q t [u(cT,) + (1 )u(cN,)] t t t=0

(31)

where Wt and Wtq denote total welfare implied by the optimal monetary policy and the

stock price targeting rule respectively. After substituting for consumption implied by each policy, using equations (15), (16) and (21), the logarithmic utility implies the following expression for total welfare loss:

W q W = E0 t=0

t ln

( + t1 )(1 + q ) (1 ) y y ( + t1 )(1 + q ) y t t ln y y

The above expression shows that there is no welfare loss if there is full participation in the nancial markets or the total dividend shocks are always equal to their mean. However,

22

any other case produces positive welfare loss. Using the parameter values from Table 1 and nancial market segmentation parameter = 0.35 we nd welfare losses for both positive and negative nancial shocks. For a positive nancial shock of 10 percent above the mean in period t, the welfare loss in period t and period t + 1 from implementing stock price targeting versus the optimal policy rule15 adds to 1.43 percent. Calculated similarly, a negative nancial shock of 10 percent below its mean in period t reduces welfare by 1.37 percent. This welfare loss is increasing with the rate of nancial segmentation, suggesting that the optimal monetary policy rule becomes more vital in economies with high nancial market participation.

4.2

Ination Volatility

In this section we examine the ination volatility that the optimal, constant money supply, ination targeting, interest rate pegging and stock price targeting policies imply, and we make comparisons across them. The general expression for ination is given by equation (25), in which we substitute the relevant policy rule. To compute the ination variance implied by the various policies, we rst linearize the ination equations around the mean dividend value and then calculate the variance for iid dividend shocks, as follows:

Var(t ) = 2 , y2

=0 Var(t ) = 2 2 , 2 y

Var(t ) = 0,

We look at two consecutive periods because the stock price targeting policy involves responses in two periods.

15

23

r Var(t ) = 22 2 , y2

q Var(t) =

(1 ) + y (1 )

2 , 2 y

for the stock price targeting monetary policy rule. Ination variance is minimized, as expected, under the ination targeting policy. Additionally, the optimal policy is always associated with less ination volatility than the constant money supply policy. The latter is true because under the optimal policy the dividend shocks from the previous period are oset, while under constant money supply they are not. These shocks increase the volatility of ination. Furthermore, a monetary authority pegging the interest rate at its equilibrium level, r+1 =

1 ,

implies zero ination volatility. Using the parameter values in Table 1 and for

any other peg between zero and one, this policy implies lower ination volatility than the optimal and constant money supply ones. Finally, using the parameter values in Table 1 and for = 0.35, the optimal monetary policy implies lower ination volatility than the stock price targeting policy.

4.3

Discussion

In this section we examined the implications that optimal monetary has for stock price volatility and ination volatility, and compare with various monetary policy rules. It is clear from our analysis that the optimal monetary policy does not necessarily associate with lower stock price volatility or ination volatility when compared to other policy rules considered. There are policies dierent from the optimal one that produce minimal stock price volatility and ination volatility. The evidence on whether or not monetary policy should respond to asset prices is conicting (Cecchetti et al., 2001; Gilchrist and Leahy, 2002; Faia and Monacelli, 2007). We nd that the optimal monetary policy rule does not produce necessarily lower stock

24

price volatility than what the constant money supply policy does; it produces lower stock price volatility than the ination targeting policy for some targets and from the interest rate peg policy for some pegs. The results depend on the parameter values and on the choice of ination target and peg. We conclude that the welfare maximizing monetary policy is not in general concerned with minimizing stock price volatility. Previous literature suggests that monetary policy targeting ination, takes care of stock price volatility (Bernanke and Gertler, 2000; Bernanke and Gertler, 2001). This paper provides some counter examples: for the same parameter values, a policy that minimizes stock price volatility produces high ination volatility and a policy that minimizes ination volatility produces high stock price volatility. This is because, rst, in our model we consider dividend type of shocks. Currently distributed dividends decrease current prices and ination (through equations (14) and (25)), so a monetary authority targeting ination expands after high current dividend shocks (see equation (26)). However, currently distributed dividends increase the stream of future consumption, increasing the stock price, so a monetary authority targeting stock prices tightens after high current dividend shocks (see equation (31)). In addition, in our model we take into account limited nancial market participation, which aects the stock price targeting policy, but not the ination targeting policy. Because it is aected dierently by nancial market participation and dividend shocks, the ination targeting policy (that minimizes ination volatility) does not necessarily minimize stock price volatility. Furthermore, we see in Figure 1 that increased participation does not necessarily imply lower stock price volatility. This observation is in contrast to previous literature (Allen and Gale, 1994) arguing that high variability in stocks price is encouraged by low stock market participation. If monetary policy actions are taken into account, as they are in this model, the eect of the increased nancial market participation on stock price volatility becomes more complicated, and depends on the specic monetary policy followed. Finally, we derive a monetary policy rule that aims in keeping constant the stock price and we nd that there is welfare loss from implementing this rule instead of the optimal one. The welfare loss disappears under full nancial market participation, revealing the misleading conclusions one can reach by omitting limited nancial market participation

25

from welfare comparisons of monetary policy rules. Concerning ination volatility we nd that the optimal monetary policy always produces lower ination volatility than what the constant money supply policy rule does. That is, the welfare maximizing monetary policy is concerned, to some extent, with sustaining stable ination.

Concluding Remarks

In conclusion, our model suggests that monetary policy should respond to stock market advances, but for reasons previous literature has not considered. Because of nancial market segmentation a novel role arises for monetary policy in order to maximize welfare, that of sharing nancial income risk only the nancial market participants face, among all agents in the economy. Monetary policy optimally expands in bad times for the nancial markets and optimally tightens in good times for the nancial markets. This policy equalizes consumption of the two groups and agents, if given the choice, would be indierent between participating or not in the nancial markets. These results hold for any concave utility function and are not sensitive to the degree of market segmentation. We also examine optimal monetary policys implications for stock price volatility and ination volatility, and compare with other, commonly cited monetary policy rules. Our analysis suggests that optimal monetary policy is not concerned with asset price volatility, but is concerned, to some extent, with keeping ination stable.

26

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Chien, Y., Cole, H., Lustig, H., 2011. A multiplier approach to understanding the macro implications of household nance. The Review of Economic Studies 78 (1), 199234. Doepke, M., Schneider, M., 2006. Ination and the redistribution of nominal wealth. Journal of Political Economy 114 (6), 10691097. Erosa, A., Ventura, G., 2002. On ination as a regressive consumption tax. Journal of Monetary Economics 49 (4), 761795. Faia, E., Monacelli, T., 2007. Optimal interest rate rules, asset prices, and credit frictions. Journal of Economic Dynamics and Control 31 (10), 32283254. Fuerst, T. S., 1992. Liquidity, loanable funds, and real activity. Journal of Monetary Economics 29 (1), 324. Gilchrist, S., Leahy, J. V., 2002. Monetary policy and asset prices. Journal of Monetary Economics 49 (1), 7597. Grossman, S. J., Weiss, L. M., 1983. A transactions-based model of the monetary transmission mechanism. American Economic Review 73 (5), 871880. Guiso, L., Haliassos, M., Jappelli, T., 2002. Household Portfolios. The MIT Press. Guo, H., 2004. Limited stock market participation and asset prices in a dynamic economy. Journal of Financial and Quantitative Analysis 39 (3), 495516. Guvenen, F., Kuruscu, B., 2006. Does market incompleteness matter for asset prices? Journal of the European Economic Association 4 (2-3), 484492. Khan, A., Thomas, J., 2007. Ination and interest rates with endogenous market segmentation. Federal Reserve Bank of Philadelphia Working Paper Series 07-1. Landon-Lane, J., Occhino, F., 2008. Bayesian estimation and evaluation of the segmented markets friction in equilibrium monetary models. Journal of Macroeconomics 30 (1), 444461. Lucas, R. E., 1978. Asset prices in an exchange economy. Econometrica 46 (6), 14291445.

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