Monetary policies should offset market sentiment –
a theory model and policy simulation
David Daokui LI
Jin WANG
Junxin FENG
Abstract
The global financial crisis in 2008 has caused academics and policy makers to rethink monetary policy theories. Using expanded monetary quantity equations and Phillips Curve, this paper establishes a new framework of monetary policy theory model, which incorporates the factors of market sentiment and assets prices. The model discusses the relationship among market sentiment, monetary policy and real economy. Analysis based on this model shows that market sentiment and monetary policy combined could influence assets prices. Consequently, the paper suggests that monetary policy should consider and offset market sentiment. In the cases when assets prices fluctuate excessively, the monetary policy that aims to stabilize the production output as a part of its l goal should function to offset the irrational market sentiment. Additionally, we did a policy simulation based on China’s historical economic data. The simulation leads to the following conclusions. If there is a 25% sentiment rise in the capital market, the short-term effect of that would be a drop in price level: under such circumstances, if stabilizing the output is the only political goal of monetary authorities then M2 should be reduced by around 1.7%; if the government wants to maintain the price level, monetary authorities should increase M2 by 2.2%; if the government target is to achieve both of these goals mentioned, then the monetary authorities should increase M2 by around 0.28%.
Key Words: Monetary Policies; Asset Price; Market Sentiment