Boundedly Rational Stock Markets and Endogenous Bubbles in a Financial DSGE Model
We develop and provide a microfoundation for a monetary New Keynesian model where stock market prices have real impact. We assume that firms rely on credit to finance production and stock prices indicate the value of their collateral. Households and firms are rational but financial market traders are boundedly rational. Our model shows that this can lead to large, persistent bubbles in stock prices, which amplify real shocks and can be followed by severe recessions. We also show that this can lead to a high perceived persistence of real shocks, which further destabilizes the economy. By running detailed simulation experiments on potential central bank policies we conclude that under reasonable behavioral assumptions monetary policy can stabilize the economy and prevent asset price bubbles by modestly reacting to movements in the stock market. This result is independent of whether the central bank is able to identify asset bubbles or not.
Lunch will be provided!
Please contact Myrna Hennequin if you have any questions about the lecture.