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Welfare analysis of non-fundamental asset price and investment shocks: implications for monetary policy

In: Investigating the relationship between the financial and real economy

  • Frank Smets

    (European Central Bank)

  • Raf Wouters

    (National Bank of Belgium)

Using a sticky price-wage model with capital accumulation and adjustment costs, this paper analyses the welfare effects of non-fundamental asset price and investment fluctuations for the representative household. The welfare effect depends strongly on the steady state level around which the economy is fluctuating. If output is below the first best competitive equilibirum because of the existence of markups in a monopolisitc competitive environment, asset price booms and the resulting positive investment and demand effects move the economy in the direction of the efficient output and can therefore be welfare improving. In such a case, optimal monetary policy will no longer be characterised by a symmetric response to inflation and output movements around the steady state, but will typically need to adjust asymmetrically

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This chapter was published in:
  • Bank for International Settlements, 2005. "Investigating the relationship between the financial and real economy," BIS Papers, Bank for International Settlements, number 22, December.
  • This item is provided by Bank for International Settlements in its series BIS Papers chapters with number 22-09.
    Handle: RePEc:bis:bisbpc:22-09
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    1. Andrew Levin & Eric Swanson, 2004. "Optimal Monetary Policy in an Imperfect World," Computing in Economics and Finance 2004 235, Society for Computational Economics.
    2. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
    3. Jinill Kim & Sunghyun Henry Kim & Ernst Schaumburg & Christopher A. Sims, 2003. "Calculating and using second order accurate solutions of discrete time dynamic equilibrium models," Finance and Economics Discussion Series 2003-61, Board of Governors of the Federal Reserve System (U.S.).
    4. Bordo, Michael D & Jeanne, Olivier, 2002. "Boom-Busts in Asset Prices, Economic Instability and Monetary Policy," CEPR Discussion Papers 3398, C.E.P.R. Discussion Papers.
    5. Christopher J. Erceg & Andrew T. Levin, 2002. "Optimal monetary policy with durable and non-durable goods," International Finance Discussion Papers 748, Board of Governors of the Federal Reserve System (U.S.).
    6. DETKEN Carsten & SMETS Frank, . "Asset Price Booms and Monetary Policy," EcoMod2003 330700042, EcoMod.
    7. Roberto Rigobon & Brian Sack, 2003. "Measuring The Reaction of Monetary Policy to the Stock Market," The Quarterly Journal of Economics, Oxford University Press, vol. 118(2), pages 639-669.
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