Real Risk-Free Rate, the Central Bank, and Stock Market Bubbles

Jukka Ilomäki; Hannu Laurila

doi:10.6000/1929-7092.2017.06.43

Authors

Jukka Ilomäki Faculty of Management, FI-33014 University of Tampere, Finland
Hannu Laurila Faculty of Management, FI-33014 University of Tampere, Finland

DOI:

https://doi.org/10.6000/1929-7092.2017.06.43

Keywords:

Real Interest Rate, Monetary Policy, Portfolio Choice

Abstract

The central bank acts as a social planner, and adjusts the real risk-free rate of return to correct any mispricing in the stock market so that the emergence of positive or negative bubbles is avoided. The analysis shows that the central bank must raise the risk-free rate in the case of a positive bubble, and vice versa. Moreover, the central bank should intervene in the stock market even if it does not have perfect information about the bubble. This is because the sequential dividend yields in the pricing equations are stationary. Thus, even the delayed reaction of the central bank prevents the fundamental value and the equilibrium price from drifting apart for extended periods.

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