Finance and Economics Discussion Series (FEDS)
June 1998
The Effect of Stock Prices on the Demand for Money Market Mutual Funds
James P. Dow, Jr., and Douglas W. Elmendorf
Abstract:
Recent empirical research concerning the relationship between in ation and unemployment, a relationship that is central to the design of monetary policy, has been characterized by an active debate about the precision of relevant parameter estimates such as the estimated natural unemployment rate. This paper studies the optimal monetary policy in the presence of uncertainty about the natural rate and the short-run inflation-unemployment tradeoff in a simple macroeconomic model. Two con icting motives drive the optimal pol- icy. In the static version of the model, uncertainty provides a motive for the policymaker to move more cautiously than she would if she knew the true parameters. In the dynamic version, uncertainty also motivates an element of experimentation in policy. I find that the optimal policy that balances the cautionary and activist motives typically exhibits gradual- ism, i.e. it is less aggressive than a policy that disregards parameter uncertainty. Exceptions occur when uncertainty is very high and in ation close to target.
Full paper (221 KB Postscript)Keywords: Money, stock prices
PDF: Full Paper
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