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The Fed Put and Monetary Policy: An Imperfect Knowledge Approach

This paper argues that a central bank can increase macroeconomic stability by reacting explicitly to stock prices and therefore rationalizes the observed empirical evidence of the "Fed put". Waves of optimism/ pessimism, unrelated to fundamental developments in the economy affect stock prices and aggregate demand through wealth effects which appear due to imperfect knowledge of the economy. Monetary policy can dampen these effects by influencing agents' expectations about stock prices and therefore eliminate the non-fundamental effects of booms and busts in stock prices. Reacting explicitly and transparently to stock prices increases welfare by 0.15% on average per period and brings efficiency gains compared to the standard Fed put policy.