Optimal Monetary Policy and Stock Market Fluctuations

Abstract

This study investigates the monetary policy rule including money growth and optimal Ramsey policy in restraining the stock market Fluctuations. We apply a new Keynesian monetary framework with nominal wage and price rigidities within a DSGE model for Iranian economy.

Bubbles in our model emerge through a positive feedback loop mechanism supported by self-fulfilling beliefs. The sentiment shock, which represents the size of current bubbles relative to newly born bubbles, causing bubbles movement and it transfers to the real economy through endogenous credit constraint. Moreover, this study investigates the impulse and response between sentiment shock and fluctuation in aggregate variables.

Our empirically findings show that: first, applying Ramsey optimal monetary policy decreases the central bank’s loss function, relative to monetary policy rule with money growth. Second, the sentiment shock drives the movements of stock market fluctuations and variations in real economy, leading to explain the positive contemporaneous correlation between stock prices and the real economy and it helps explaining the business cycles in Iran.