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Should monetary policy respond to asset price bubbles? : some experimental results

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  • Andrew J. Filardo
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    Abstract

    Should central banks respond to asset price bubbles? This paper explores this monetary policy question in a hypothetical economy subject to asset price bubbles. Despite the highly stylized structure of the model, the results reveal several practical monetary policy lessons. First, a monetary authority should generally respond to asset prices as long as asset prices contain reliable information about inflation and output. Second, this finding holds even if a monetary authority cannot distinguish between fundamental and bubble asset price behavior. Third, a monetary authority’s desire to respond to asset prices falls dramatically as its preference to smooth interest rates rises. Finally, a monetary authority should not respond to asset prices if there is considerable uncertainty about the macroeconomic role of asset prices.

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    File URL: http://www.kansascityfed.org/Publicat/Reswkpap/pdf/rwp01-04.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 01-04.

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    Date of creation: 2001
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    Handle: RePEc:fip:fedkrw:rwp01-04

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    Keywords: Monetary policy ; Asset pricing;

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    1. Rudebusch, G.D. & Svensson, L.E.O., 1998. "Policy Rules for Inflation Targeting," Papers 637, Stockholm - International Economic Studies.
    2. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
    3. Ben S. Bernanke & Michael Woodford, 1997. "Inflation Forecasts and Monetary Policy," NBER Working Papers 6157, National Bureau of Economic Research, Inc.
    4. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
    5. Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 77-128.
    6. James M. Poterba, 2000. "Stock Market Wealth and Consumption," Journal of Economic Perspectives, American Economic Association, vol. 14(2), pages 99-118, Spring.
    7. Goodhart, Charles & Hofmann, Boris, 2000. "Do Asset Prices Help to Predict Consumer Price Inflation?," Manchester School, University of Manchester, vol. 68(0), pages 122-40, Supplemen.
    8. Morris A. Davis & Michael G. Palumbo, 2001. "A primer on the economics and time series econometrics of wealth effects," Finance and Economics Discussion Series 2001-09, Board of Governors of the Federal Reserve System (U.S.).
    9. Stephen G. Cecchetti & Anil K Kashyap, 1995. "International Cycles," NBER Working Papers 5310, National Bureau of Economic Research, Inc.
    10. Timothy Cogley, 1999. "Should the Fed take deliberate steps to deflate asset price bubbles?," Economic Review, Federal Reserve Bank of San Francisco, pages 42-52.
    11. West, Kenneth D, 1987. "A Specification Test for Speculative Bubbles," The Quarterly Journal of Economics, MIT Press, vol. 102(3), pages 553-80, August.
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    Cited by:
    1. Disyatat, Piti, 2010. "Inflation targeting, asset prices, and financial imbalances: Contextualizing the debate," Journal of Financial Stability, Elsevier, vol. 6(3), pages 145-155, September.
    2. Albulescu, Claudiu Tiberiu, 2013. "Financial Stability and Monetary Policy: A Reduced-Form Model for the EURO Area," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 0(1), pages 62-81, March.
    3. Helmut Wagner & Wolfram Berger, 2003. "Financial Globalization and Monetary Policy," DNB Staff Reports (discontinued) 95, Netherlands Central Bank.
    4. Helmut Wagner & Wolfram Berger, 2004. "Globalization, Financial Volatility and Monetary Policy," Empirica, Springer, vol. 31(2), pages 163-184, June.
    5. Hoffmann, Andreas, 2013. "Did the Fed and ECB react asymmetrically with respect to asset market developments?," Journal of Policy Modeling, Elsevier, vol. 35(2), pages 197-211.
    6. Siklos, Pierre L. & Bohl, Martin T. & Werner, Thomas, 2003. "Did the Bundesbank React to Stock Price Movements?," Discussion Paper Series 1: Economic Studies 2003,14, Deutsche Bundesbank, Research Centre.
    7. Kim, Soyoung & Yang, Doo Yong, 2008. "The Impact of Capital Inflows on Emerging East Asian Economies: Is Too Much Money Chasing Too Little Good?," Working Papers on Regional Economic Integration 15, Asian Development Bank.
    8. Fabrizio Zampolli, 2004. "Optimal monetary policy in a regime-switching economy," Computing in Economics and Finance 2004 166, Society for Computational Economics.
    9. Luís, Pacheco, 2004. "Asset Prices and Monetary Policy in the Euro Area: a tentative model," MPRA Paper 6579, University Library of Munich, Germany.
    10. I. Arnold & P.J.A. van Els & J. de Haan, 2002. "Wealth Effects and Monetary Policy," WO Research Memoranda (discontinued) 719, Netherlands Central Bank, Research Department.
    11. Elmer Sterken, 2004. "The Role of the IFO Business Climate Indicator and Asset Prices in German Monetary Policy," CESifo Working Paper Series 1204, CESifo Group Munich.
    12. Dai, Meixing & Sidiropoulos, Moïse, 2003. "Les prix des actifs et la stratégie de politique monétaire de la BCE
      [Asset prices and the monetary policy strastegy of the ECB]
      ," MPRA Paper 13833, University Library of Munich, Germany, revised Jul 2003.
    13. Dai, Meixing & Sidiropoulos, Moïse, 2002. "Règle du taux d'intérêt optimale, prix des actions et taux d'inflation anticipé : une étude de la stabilité macroéconomique
      [Optimal interest rate rule, asset prices and expected inflation r
      ," MPRA Paper 14401, University Library of Munich, Germany, revised Jun 2003.
    14. Jan Willem van den End, 2006. "Indicator and boundaries of financial stability," DNB Working Papers 097, Netherlands Central Bank, Research Department.
    15. Hoffmann, Andreas, 2009. "Fear of depression - Asymmetric monetary policy with respect to asset markets," MPRA Paper 17522, University Library of Munich, Germany.
    16. Zampolli, Fabrizio, 2006. "Optimal monetary policy in a regime-switching economy: The response to abrupt shifts in exchange rate dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 30(9-10), pages 1527-1567.
    17. Greg Tkacz & Carolyn Wilkins, 2006. "Linear and Threshold Forecasts of Output and Inflation with Stock and Housing Prices," Working Papers 06-25, Bank of Canada.

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