Monetary policy and asset prices: a Markov-switching DSGE approach

This paper estimates a Markov-switching dynamic stochastic general equilibrium model by incorporating stock prices in monetary policy rules in order to identify the Federal Reserve’s stance toward them. Based on the data from 1984:Q1 to 2009:Q2, I find that historical evidence of the policy reaction toward stock prices is weak except for the stock market bubble of the 1990s. A counterfactual exercise shows that the rapid growth in stock prices during that period would have been significantly higher if monetary policy had been independent of the stock market. However, unconditional macroeconomic volatility increases with the degree of policy responsiveness toward stock prices.