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Expectations, Asset Prices, and Monetary Policy: The Role of Learning

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Author Info
Simon Gilchrist
Masashi Saito

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Abstract

This paper studies the implications of financial market imperfections represented by a countercyclical external finance premium and the gradual recognition of changes in the drift of technology growth for the design of an interest rate rule. Asset price movements induced by changes in trend growth influence balance-sheet conditions that determine the external finance premium. Such movements are magnified when the private sector is imperfectly informed regarding the trend growth rate of technology. The presence of financial market imperfections provides a motivation for responding to the gap between the observed asset prices and the potential level of asset prices in addition to responding strongly to inflation. This is because the asset price gap represents distortions in the resource allocation induced by financial market imperfections more distinctly than inflation. The policymaker's imperfect information about the drift of technology growth renders imprecise the calculation of the potential and thus reduces the benefit of responding to the asset price gap. A policy that responds to the level of asset prices which does not take into account changes in potential tends to be welfare reducing.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12442.

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Date of creation: Aug 2006
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Handle: RePEc:nbr:nberwo:12442

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Find related papers by JEL classification:
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
O41 - Economic Development, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models

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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. Francisco Covas & Yahong Zhang, 2008. "Price-Level versus Inflation Targeting with Financial Market Imperfections," Working Papers 08-26, Bank of Canada. [Downloadable!]
  2. Pfajfar, D. & Santoro, E., 2008. "Credit Market Distortions, Asset Prices and Monetary Policy," Cambridge Working Papers in Economics 0825, Faculty of Economics, University of Cambridge. [Downloadable!]
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