MACRO: A Monetary Policy Asset Pricing Model; Professor Ricardo CABALLERO (Massachusetts Institute of Technology)

Abstract

We propose a model where monetary policy is the key determinant of aggregate asset prices (financial conditions). Spending decisions are made by a group of agents ("households") that respond to aggregate asset prices, but with noise, delays, and inertia. Asset pricing is determined by a different group of forward-looking agents ("the market"). The central bank ("the Fed") targets asset prices to close the output and inflation gaps. Our model explains several facts, including why the Fed stabilizes asset price fluctuations driven by financial market shocks ("the Fed put/call"), but destabilizes asset prices in response to aggregate demand or supply shocks that induce positive output gaps and inflation (as in the late stages of the Covid-19 recovery). When the market and the Fed have different beliefs, the market perceives monetary policy “mistakes” that induce a policy risk premium. Belief disagreements may also generate a "behind the curve" phenomenon and provide a microfoundation for monetary policy shocks driven by the Fed's belief surprises.

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