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Financial asset prices and monetary policy: theory and evidence

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Author Info
Frank Smets (European Central Bank (ECB))

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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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Publisher 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
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Handle: RePEc:bis:biswps:47

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  2. 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. [Downloadable!] (restricted)
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    Other versions:
  5. Clarida, Richard & Galí, Jordi, 1994. "Sources of Real Exchange Rate Fluctuations: How Important are Nominal Shocks?," CEPR Discussion Papers 951, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  6. Gruen, David W R & Wilkinson, Jenny, 1994. "Australia's Real Exchange Rate--Is It Explained by the Terms of Trade or by Real Interest Differentials?," The Economic Record, The Economic Society of Australia, vol. 70(209), pages 204-19, June.
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  13. 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. [Downloadable!] (restricted)
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  15. Canzoneri, Matthew B & Henderson, Dale W & Rogoff, Kenneth S, 1983. "The Information Content of the Interest Rate and Optimal Monetary Policy," The Quarterly Journal of Economics, MIT Press, vol. 98(4), pages 545-66, November. [Downloadable!] (restricted)
    Other versions:
  16. 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. [Downloadable!] (restricted)
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  17. 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.
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  21. Arthur Grimes & Jason Wong, 1992. "The role of the exchange rate in New Zealand monetary policy," Proceedings, Federal Reserve Bank of San Francisco, pages 176-197.
    Other versions:
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Carsten Detken & Vincent Brousseau, 2001. "Monetary policy and fears of financial instability," Working Paper Series 089, European Central Bank. [Downloadable!]
  2. Fernando Alexandre, 2002. "Monetary Policy, Investment and Non-Fundamental Shocks," NIPE Working Papers 6/2002, NIPE - Universidade do Minho. [Downloadable!]
    Other versions:
  3. Christopher Kent & Philip Lowe, 1997. "Asset-price Bubbles and Monetary Policy," RBA Research Discussion Papers rdp9709, Reserve Bank of Australia. [Downloadable!]
  4. Fernando Alexandre & John Drifill & Fabio Spagniolo, 2001. "Inflation Targeting and Exchange Rate Co-ordination," NIPE Working Papers 9/2001, NIPE - Universidade do Minho. [Downloadable!]
  5. Fernando Alexandre & Pedro Bação, 2002. "Equitity prices and Monetary Policy: An Overview with an Exploratory Model," NIPE Working Papers 1/2002, NIPE - Universidade do Minho. [Downloadable!]
    Other versions:
  6. Chris Ryan & Christopher Thompson, 2000. "Inflation Targeting and Exchange Rate Fluctuations in Australia," RBA Research Discussion Papers rdp2000-06, Reserve Bank of Australia. [Downloadable!]
  7. Bohl, Martin T. & Siklos, Pierre L. & Werner, Thomas, 2003. "Did the Bundesbank React to Stock Price Movements?," Discussion Paper Series 1: Economic Studies 2003,14, Deutsche Bundesbank, Research Centre. [Downloadable!]
  8. Wong Keung-Wing & Habibullah Khan & Jun Du, 2006. "Money, Interest Rate and Stock Prices: New Evidence from Singapore and The United States," Departmental Working Papers wp0601, National University of Singapore, Department of Economics. [Downloadable!]
  9. West, L.k. & Agbola, W.F., 2005. "Causality Links Between Asset Prices And Cash Rate In Australia," International Journal of Applied Econometrics and Quantitative Studies, Euro-American Association of Economic Development, vol. 2(3), pages 69-86. [Downloadable!]
  10. Lynn Elaine Browne & Rebecca Hellerstein & Jane Sneddon Little, 1998. "Inflation, asset markets, and economic stabilization: lessons from Asia," New England Economic Review, Federal Reserve Bank of Boston, issue Sep, pages 3-32. [Downloadable!]
  11. Michael D. Bordo & David C. Wheelock, 2004. "Monetary Policy and Asset Prices: A Look Back at Past U.S. Stock Market Booms," NBER Working Papers 10704, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  12. Abdelaziz Rouabah, 2006. "L'identité de Fisher et l'interaction entre l'inflation et la rentabilité des actions: l'importance des régimes sous-jacents aux marchés boursiers," BCL working papers cahier_etude_18, Central Bank of Luxembourg. [Downloadable!]
  13. G. C. Lim & Paul D. McNelis, 2006. "Inflation Targeting, Learning and Q Volatility in Small Open Economies," Melbourne Institute Working Paper Series wp2006n22, Melbourne Institute of Applied Economic and Social Research, The University of Melbourne. [Downloadable!]
    Other versions:
  14. Ivo J.M. Arnold & Clemens J.M. Kool, 2003. "The Role of Inflation Differentials in Regional Adjustment: Evidence from the United States," Working Papers 04-13, Utrecht School of Economics. [Downloadable!]
  15. Ram Sharan Kharel & Christopher Martin & Costas Milas, 2006. "The Complex Response of Monetary Policy to the Exchange Rate," Keele Economics Research Papers KERP 2006/17, Centre for Economic Research, Keele University. [Downloadable!]
    Other versions:
  16. P. Siklos & M. Bohl, 2006. "Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule," Working Papers eg0053, Wilfrid Laurier University, Department of Economics, revised 2006. [Downloadable!]
    Other versions:
  17. Christophe Blot & Grégory Levieuge, 2008. "Are MCIS good indicators of economic activity? Evidence from the G7 countries," Documents de Travail de l'OFCE 2008-07, Observatoire Francais des Conjonctures Economiques (OFCE). [Downloadable!]
  18. Quentin Wibaut, 2000. "Politique monétaire et prix des actifs: le cas des Etats-Unis," Documents series 200008-3, National Bank of Belgium. [Downloadable!]
  19. H. Genberg, 2001. "Asset Prices, Monetary Policy and Macroeconomic Stability," DNB Staff Reports (discontinued) 64, Netherlands Central Bank. [Downloadable!]
  20. Nuno Cassola & Claudio Morana, 2002. "Monetary policy and the stock market in the Euro area," Working Paper Series 119, European Central Bank. [Downloadable!]
  21. Helmut Wagner & Wolfram Berger, 2003. "Financial Globalization and Monetary Policy," DNB Staff Reports (discontinued) 95, Netherlands Central Bank. [Downloadable!]
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