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

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 flip side is that if the real risk-free rate is fixed, it incorporates inefficiency into the financial market. Setting a zero bound for the risk-free rate constrains the adjustment in the case of negative bubbles, and the fixed negative risk-free rate in the market not only prevents the adjustment of possible positive bubbles but may also lead to rampant instability in the market. The paper also points out the limits of manageable control of mispricing. In addition, the analysis indicates that the central bank should intervene in the stock market even if it does not have perfect information about the bubble.