a) The rising stock market implies an increase in wealth, at least as measured on paper. If we assume that some of this increased wealth gets consumed, then the rising stock market fuels an increase in aggregate demand, and may contribute to an inflationary gap. This is shown by a rightward shift in the AD curve, possibly raising GDP above Y*.

b) In this case, a tightening of monetary policy may be appropriate as a means of keeping output near potential. A tightening of monetary policy will, in general, slow the rise in the stock market, and may cause an outright fall in stock-market values. This is because, first, a rise in interest rates reduces the PV of any given flow of earnings and, second, the monetary tightening reduces the future steam of firms’ profits. Thus a monetary tightening will reduce values in the stock market and reduce wealth, thus leading to less desired consumption expenditure.

One problem with monetary tightening in this situation is that it is difficult to determine precisely how much to tighten. It is relatively easy to measure the increase in wealth associated with an increase in stock-market values. But it is difficult to know by how much aggregate expenditure is increasing as a result.

c) A sudden crash in the stock market reduces the amount of wealth and thus reduces desired aggregate expenditure. This is a leftward shift in the AD curve. It may also lead firms to reduce their desired investment if they are unable to finance their projects by the issuance of new shares.