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Asset Price and Monetary Policy - The Effect of Expectation Formation

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  • Nan-Kuang Chen

    (National Taiwan University and Hong Kong Institute for Monetary Research)

  • Han-Liang Cheng

    (Chung-Hua Institution for Economic Research)

Abstract

This paper is a theoretical study of the effects of monetary policy reacting to fluctuations in asset price, accounting for the expectation formation effect of policy regime shift in a DSGE model calibrated to the U.S. economy. We find that the effect of expectation formation can substantially influence the movement of asset price. In contrast to the linear policy rule, under the regime switching policy rule reacting to asset price can generate substantial stabilization effect: the "expected" inflation-output volatility frontier shifts downward, thereby lowering both the volatilities of inflation and output for all possible policy choices. The trade-off between the expected volatility of inflation and that of output, as demonstrated by the "Taylor curve," greatly diminishes, implying that the Taylor rule which considers expectation formation effect and asset price movement expands the set of monetary policy choices available for monetary authority.

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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 032011.

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Length: 41 pages
Date of creation: Jan 2011
Date of revision:
Handle: RePEc:hkm:wpaper:032011

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Keywords: Asset Price; Monetary Policy; Regime Switching; DSGE;

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  1. Henrik Jensen, 2002. "Targeting Nominal Income Growth or Inflation?," American Economic Review, American Economic Association, vol. 92(4), pages 928-956, September.
  2. Assenmacher-Wesche, Katrin & Gerlach, Stefan, 2008. "Ensuring financial stability: Financial structure and the impact of monetary policy on asset prices," IMFS Working Paper Series 16, Institute for Monetary and Financial Stability (IMFS), Goethe University Frankfurt.
  3. Paolo Surico & Antonello D'Agostino & Luca Sala, 2005. "The Fed and the Stock Market," Computing in Economics and Finance 2005 293, Society for Computational Economics.
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