Discussion Paper
No. 2011-54 | December 22, 2011
Michele Grossi and Roberto Tamborini
Stock Prices and Monetary Policy: Re-examining the Issue in a New Keynesian Model with Endogenous Investment

Abstract

In this paper, the authors present a New Keynesian quantitative model with endogenous investment and a stock-market sector to shed further light on two unsettled issues: whether central banks should include some financial indicator in their policy rules, and what indicator may be expected to generate better stabilization performance. For comparative purposes, the authors replicate the policy framework and assessment strategy of the well-known 'no-inclusion' model of Bernanke–Gertler (1999, 2000) and assess performance of five policy rules. Two of these are 'traditional' Taylor rules (i.e., do not incorporate financial indicators) that differ in the relative weight they put on output and inflation gaps. The other three are 'financial' Taylor rules. These involve the addition of one financial indicator in each case. Specifically, the deviation from trend of stock prices, of Tobin's q (the rate of change in stock prices relative to capital stock) and of investment. The authors obtain results that are at variance with Bernanke–Gertler, first, because the best performing rule of the traditional rules is output aggressive instead of inflation aggressive and, second, because the financial rule with Tobin's q outperforms the traditional inflation-aggressive one under all dimensions and cases. However, the authors cannot draw a univocal conclusion as regards the comparison between the financial rule with Tobin's q and the traditional but output aggressive rule.

JEL Classification:

E5, E52

Links

Cite As

[Please cite the corresponding journal article] Michele Grossi and Roberto Tamborini (2011). Stock Prices and Monetary Policy: Re-examining the Issue in a New Keynesian Model with Endogenous Investment. Economics Discussion Papers, No 2011-54, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2011-54


Comments and Questions



Anonymous - Referee Report 1
January 23, 2012 - 09:48
see attached file

Anonymous - Reply to referee report 1
February 02, 2012 - 10:06
see attached file

Anonymous - Referee Report 2
February 09, 2012 - 08:59
see attached file

Livio Stracca - Good focus but model still too ad hoc
February 17, 2012 - 13:27
I liked the paper and in particular the link between stock price bubbles and investment, allowing for the possibility of over-investment. At the same time I think the paper is still not sufficiently clear and well developed on the structural reasons why (i) stock price bubbles depend on interest rates, and (ii) how stock prices affect investment. Just to make an example, I could not see where equation (6) came from, or what the intuition behind it is. Also, the bubble process is just introduced (top of page 9) with much further justification. Finally, on this topic most readers will think about the Christiano et al (2007) paper, it would therefore be useful to be clear on where the current paper departs from that work and why it matters. I look forward to read a revised version.

ROBERTO TAMBORINI - Reply to L. Stracca
February 21, 2012 - 23:22
The issues (i) and (ii) are addressed on pp. 5 to 10, and they result from the mathematical treatment of the optimal investment decision of firms quoted in the stock market. To begin with, equation (6), which represents optimal investment in terms of Tobin's 'q' with adjustment costs, "comes out" as the first order condition of the maximization of the expected profit equation (4) (the proof is in Appendix A1). Then, we derive mathematically the relationship between the firm's stock market value and optimal investment, which is a direct derivation of the fundamental valuation principle of stock prices. The result is in line with Tobins's theory: 'q' is the ratio of the stock market value to the replacement cost of capital (see eqs. 8 to 12); a higher stock market value raises 'q' and hence induces new investment (according to eq. 6). We have revised the maths, and we have found it is correct. But if there is any mistake we are unaware of, we are ready to correct it.[More in the attached file]

Anonymous - Report
February 18, 2012 - 11:00
Report: see attached file

Roberto Tamborini - Reply to Report
February 29, 2012 - 08:35
see attached file