Monetary Policy and Asset Prices: A Mechanism Design Approach

Abstract

We investigate the effects of monetary policy on asset prices in economies where assets are traded periodically in bilateral meetings. The trading mechanism is designed to maximize social welfare taking as given the frictions in the environment and monetary policy. We show that asset price “bubbles” emerge in a constrained‐efficient monetary equilibrium only if liquidity is abundant and the first‐best allocation is implementable. In contrast, if liquidity is scarce, assets are priced at their fundamental value in any constrained‐efficient monetary equilibrium, in which case an increase in inflation has no effect on asset prices, but it reduces output and welfare.