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23 Sep 2008

Stock Prices and Monetary Policy

Paul De Grauwe

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The question of whether central banks should target stock prices so as to prevent bubbles and crashes from occurring has been hotly debated. This paper analyses this question using a behavioural macroeconomic model. This model generates bubbles and crashes. It analyses how ‘leaning against the wind’ strategies, which aim to reduce the volatility of stock prices, can help in reducing volatility of output and inflation. We find that such policies can be effective in reducing macroeconomic volatility, thereby improving the trade-off between output and inflation variability. The strength of this result, however, depends on the degree of credibility of the inflation-targeting regime. In the absence of such credibility, policies aiming at stabilising stock prices do not stabilise output and inflation.

Paul De Grauwe is Professor of Economics at the University of Leuven and Associate Senior Fellow at CEPS. He has written a shorter CEPS Policy Brief on this same subject (No. 171/September 2008).