Distortions in financial markets and monetary policy

• Main Author: Hansen, James
• Published: London School of Economics and Political Science (University of London) 2012
• Subjects: 332.4; HB Economic Theory
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.570993

This thesis investigates distortions in credit and equity markets. It provides insight into sources of volatility in these markets and their implications for monetary policy. Chapter 2 analyses optimal monetary policy in an economy with a credit friction and capital. A central bank implementing policy optimally will face a trade-off in stabilising inflation, the composition of output, and the net worth of borrowers. The importance of net worth is a new finding in the literature, and reflects the central bank's concern that distortions in credit markets can reduce welfare if ignored. In addition, it is shown that some tolerance of inflation can be optimal in response to shocks that reduce borrowers' net worth. Chapter 3 considers distortions in equity markets and their implications for economic decision-making. It analyses whether changes in the distribution of technology, coupled with optimal expectations on the part of investment-firm managers, can induce endogenous optimism or pessimism. And whether this optimism or pessimism can in turn lead to equity mispricing, and distorted economic decisions. Using a simple general equilibrium model, it is shown that a favourable change in the distribution of technology can induce endogenous optimism leading to over-valued equity prices and over-investment, when compared with an economy in which rational expectations are used. Chapter 4 focuses on identifying the effects of mispriced equity. I find that equity mispricing has statistically significant effects on household consumption and portfolio allocation decisions. These effects are estimated to be non-trivial when allowing for episodes of significant mispricing such as an equity price bubble. Taken together, these chapters suggest that distortions in credit and equity markets can be important, and should be taken into consideration by policymakers to the extent that they affect real economic decisions.