Financial Market Segmentation, Stock Market Volatility and the Role of Monetary Policy

We explore the role of monetary policy in a world of segmented nancial markets, where the agents who trade stocks encounter nancial income risk although the rest do not. In such an economy, we ask the question of how the monetary authority operates when it aims to maximize total welfare. We nd that optimal monetary policy has the novel role of sharing the nancial market risk traders face, among all agents in the economy. This nding holds for any concave utility function and is not sensitive to the degree of market segmen- tation. When risk is shared perfectly in this way, consumption is equalized between the two groups, and agents, if given the choice, would be indierent between participating or not in the nancial markets. We also explore the im- plications that this policy has for the volatility of stock prices and of ination, when compared to the policies of constant money supply, ination targeting and nominal interest rate pegging. We nd that optimal monetary policy is not necessarily associated either with minimal stock price volatility or with minimal ination volatility.