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Financial Condition Index and interest rate settings: a comparative analysis

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  • Alberto Montagnoli
  • Oreste Napolitano

Abstract

In the last thirty years, there has been a widespread move towards financial liberalisation, both within and across national borders. This economic development brought researchers to investigate the link between asset prices, inflation and the conduct of monetary policy. Starting from the seminal work of Alchian and Klein (1973) it is often argued that the forward-looking nature of asset prices makes them good proxies for the information left out of conventional inflation measures. It is also widely accepted that asset price inflation developments are closely associated with general inflation trends. This paper investigates the role of asset prices in the conduct of monetary policy in United States, Canada, Euro Area and United Kingdom. It has two focal points. First, we construct Financial Condition Indexes for four countries using the Kalman Filter algorithm. This methodology allows us to capture the changes of the weights associated with each financial variable in explaining the output gap over time. Second, we proceed by estimating forward-looking Taylor rules augmented for FCI. Our results suggest that the Financial Condition Index enter positively and statistically significant into the FED, Bank of England and Bank of Canada interest rate setting. This gives a positive view for the use of the FCI as an important short term indicator to guide the conduct of monetary policy in three out of four countries analyzed.

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Bibliographic Info

Paper provided by D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy in its series Discussion Papers with number 2_2006.

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Date of creation: 15 Jan 2006
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Handle: RePEc:prt:dpaper:2_2006

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Keywords: Financial Condition Index; Optimal Monetary Policy; Taylor rule.;

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References

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  1. Tro Kortian, 1995. "Modern Approaches to Asset Price Formation: A Survey of Recent Theoretical Literature," RBA Research Discussion Papers, Reserve Bank of Australia rdp9501, Reserve Bank of Australia.
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Cited by:
  1. Angelopoulou, Eleni & Balfoussia, Hiona & Gibson, Heather D., 2014. "Building a financial conditions index for the euro area and selected euro area countries: What does it tell us about the crisis?," Economic Modelling, Elsevier, Elsevier, vol. 38(C), pages 392-403.
  2. Esteban Gómez & Andrés Murcia Pabón & Nancy Zamudio Gómez, . "Financial Conditions Index: Early and Leading Indicator for Colombia?," Temas de Estabilidad Financiera, Banco de la Republica de Colombia 055, Banco de la Republica de Colombia.
  3. Vítor Castro, 2008. "Are Central Banks following a linear or nonlinear (augmented) Taylor rule?," NIPE Working Papers, NIPE - Universidade do Minho 19/2008, NIPE - Universidade do Minho.
  4. Vítor, Castro, 2011. "Can central banks' monetary policy be described by a linear (augmented) Taylor rule or by a nonlinear rule?," Journal of Financial Stability, Elsevier, Elsevier, vol. 7(4), pages 228-246, December.
  5. Swamy, Vighneswara, 2013. "Banking System Resilience and Financial Stability - An Evidence from Indian Banking," MPRA Paper 49597, University Library of Munich, Germany.
  6. Oreste Napolitano, 2006. "Is The Impact Of Ecb Monetary Policy On Emu Stock Market Returns Asymmetric?," Working Papers, D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy 3_2006, D.E.S. (Department of Economic Studies), University of Naples "Parthenope", Italy.
  7. Swamy, Vighneswara, 2013. "Banking System Resilience and Financial Stability," MPRA Paper 47512, University Library of Munich, Germany.
  8. Jan Willem van den End, 2006. "Indicator and boundaries of financial stability," DNB Working Papers, Netherlands Central Bank, Research Department 097, Netherlands Central Bank, Research Department.
  9. Kirsten Thompson & Renee van Eyden & Rangan Gupta, 2013. "Identifying a financial conditions index for South Africa," Working Papers 201333, University of Pretoria, Department of Economics.

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