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Financial asset prices and monetary policy: theory and evidence

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  • Frank Smets

    (European Central Bank (ECB))

Abstract

The work presented in this paper falls into two parts. First, using a simple model and within the context of the central bank's objective of price stability, it is shown that the optimal monetary response to unexpected changes in asset prices depends on how these changes affect the central bank's inflation forecast, which in turn depends on two factors: the role of the asset price in the transmission mechanism and the typical information content of innovations in the asset price. In this context, the advantages and disadvantages of setting monetary policy in terms of a weighted average of a short-term interest rate and an asset price such as the exchange rate - a Monetary Conditions Index (MCI) - are discussed. The second, more empirical, part of the paper documents, using an estimated policy reaction function, the short-term response to financial asset prices, including the exchange rate, in two countries with inflation targets (Australia and Canada) and suggests that the different response to exchange rate changes in these countries can in part be explained by differences in their underlying sources.

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Bibliographic Info

Paper provided by Bank for International Settlements in its series BIS Working Papers with number 47.

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Length: 35 pages
Date of creation: Sep 1997
Date of revision:
Handle: RePEc:bis:biswps:47

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  1. Arthur Grimes, 1992. "The role of the exchange rate in New Zealand monetary policy," Pacific Basin Working Paper Series 93-03, Federal Reserve Bank of San Francisco.
  2. Broadbent, Ben & Barro, Robert J., 1997. "Central bank preferences and macroeconomic equilibrium," Journal of Monetary Economics, Elsevier, vol. 39(1), pages 17-43, June.
  3. David W.R. Gruen & Jenny Wilkinson, 1991. "Australia’s Real Exchange Rate – Is it Explained by the Terms of Trade or by Real Interest Differentials?," RBA Research Discussion Papers rdp9108, Reserve Bank of Australia.
  4. Lastrapes, William D, 1992. "Sources of Fluctuations in Real and Nominal Exchange Rates," The Review of Economics and Statistics, MIT Press, vol. 74(3), pages 530-39, August.
  5. Jeff Fuhrer & George Moore, 1989. "Monetary policy rules and the indicator properties of asset prices," Finance and Economics Discussion Series 89, Board of Governors of the Federal Reserve System (U.S.).
  6. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
  7. Guy Debelle, 1996. "The Ends of Three Small Inflations: Australia, New Zealand and Canada," Canadian Public Policy, University of Toronto Press, vol. 22(1), pages 56-78, March.
  8. Jordi Galí & Richard Clarida, 1993. "Sources of real exchage rate fluctuations: How important are nominal shocks?," Economics Working Papers 66, Department of Economics and Business, Universitat Pompeu Fabra, revised Jan 1994.
  9. Lars E. O. Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," NBER Working Papers 5797, National Bureau of Economic Research, Inc.
  10. Blanchard, Olivier Jean & Quah, Danny, 1989. "The Dynamic Effects of Aggregate Demand and Supply Disturbances," American Economic Review, American Economic Association, vol. 79(4), pages 655-73, September.
  11. William Poole, 1970. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Staff Studies 57, Board of Governors of the Federal Reserve System (U.S.).
  12. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers 1750, C.E.P.R. Discussion Papers.
  13. Fisher, Lance A, 1996. "Sources of Exchange Rate and Price Level Fluctuations in Two Commodity Exporting Countries: Australia and New Zealand," The Economic Record, The Economic Society of Australia, vol. 72(219), pages 345-58, December.
  14. Matthew B. Canzoneri & Dale W. Henderson, 1991. "Monetary Policy in Interdependent Economies: A Game-Theoretic Approach," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031787, December.
  15. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  16. Gerlach, Stefan & Smets, Frank, 2000. "MCIs and monetary policy," European Economic Review, Elsevier, vol. 44(9), pages 1677-1700, October.
  17. Cumby, Robert E. & Huizinga, John & Obstfeld, Maurice, 1983. "Two-step two-stage least squares estimation in models with rational expectations," Journal of Econometrics, Elsevier, vol. 21(3), pages 333-355, April.
  18. Enders, Walter & Lee, Bong-Soo, 1997. "Accounting for real and nominal exchange rate movements in the post-Bretton Woods period," Journal of International Money and Finance, Elsevier, vol. 16(2), pages 233-254, April.
  19. Duguay, Pierre, 1994. "Empirical evidence on the strength of the monetary transmission mechanism in Canada: An aggregate approach," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 39-61, February.
  20. Eswar Prasad & Bankim Chadha, 1996. "Real Exchange Rate Fluctuations and the Business Cycle," IMF Working Papers 96/132, International Monetary Fund.
  21. David Longworth & Brian O’Reilly, 2000. "The Monetary Policy Transmission Mechanism and Policy Rules in Canada," Working Papers Central Bank of Chile 72, Central Bank of Chile.
  22. Boyer, Russell S, 1978. "Optimal Foreign Exchange Market Intervention," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 1045-55, December.
  23. Matthew B. Canzoneri & Dale W. Henderson & Kenneth S. Rogoff, 1981. "The information content of the interest rate and optimal monetary policy," International Finance Discussion Papers 192, Board of Governors of the Federal Reserve System (U.S.).
  24. Arturo Estrella, 1997. "Why do interest rates predict macro outcomes?: A unified theory of inflation, output, interest and policy," Research Paper 9717, Federal Reserve Bank of New York.
  25. Amano, Robert A. & van Norden, Simon, 1995. "Terms of trade and real exchange rates: the Canadian evidence," Journal of International Money and Finance, Elsevier, vol. 14(1), pages 83-104, February.
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