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Authors:

• Nan-Kuang Chen
  National Taiwan University

• Han-Liang Cheng
  National Taiwan University

We study the effects of monetary policy reacting to fluctuations in asset price, taking into account of the impact arising from expectations of possible shift in policy regime between "Hawkish" and "Dovish" in a DSGE model calibrated to the U.S. economy. Firstly, we find that expectation formation effect can significantly affect the movement of the asset price. Furthermore, expectation formation effect strengthens the net gains from reacting to asset price, generating a substantially lower "expected" volatilities of inflation and output gap. In contrast, under a linear policy rule, reacting to asset price generates negligible stabilization effect in terms of output and inflation volatilities, as found in many existing works. The results have important implications for asset pricing and monetary policy while evaluating the effect of reacting to asset price.