MONETARY-POLICY RULES AND THE INDICATOR PROPERTIES OF ASSET PRICES

We investigate relationships between asset prices and inflation in a modern Keynesian model in which monetary policy controls inflation by manipulating the federal funds rate. The indicator properties of asset prices are quite sensitive to the monetary policy rule. Including the asset prices themselves in the reaction function can invert the sense of the indicator properties. Targeting the asset prices is tantamount to targeting the real interest rate: when all of the weight in the reaction function is placed on asset prices. the real rate converges so rapidly that policy loses control of inflation.