Financial asset prices and monetary policy: theory and evidence

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Financial asset prices and monetary policy: theory and evidence

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Frank Smets (European Central Bank (ECB))

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Frank Rafael Smets

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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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
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Handle: RePEc:bis:biswps:47

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Paper
- Smets, Frank, 1997. "Financial Asset Prices and Monetary Policy: Theory and Evidence," CEPR Discussion Papers 1751, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
Chapter
- Frank Smets, 1997. "Financial-asset Prices and Monetary Policy: Theory and Evidence," RBA Annual Conference Volume, in: Philip Lowe (ed.), Monetary Policy and Inflation Targeting Reserve Bank of Australia. [Downloadable!]

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Other versions:
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