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Financial Asset Prices and Monetary Policy: Theory and Evidence

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  • Smets, Frank

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, uses an estimated policy reaction function, to document 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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1751.

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Date of creation: Nov 1997
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Handle: RePEc:cpr:ceprdp:1751

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Keywords: Asset Prices; MCI; Monetary Policy;

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  1. Arthur Grimes & Jason Wong, 1992. "The role of the exchange rate in New Zealand monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
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  17. 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.
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