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Asset Prices and the Conduct of Monetary Policy

Listed author(s):
  • Goodhart, Charles

    (London School of Economics)

  • Boris Hofmann

    (University of Bonn)

In simple backward-looking structural models of the economy the optimal monetary policy rule is given by a Taylor-type interest rate rule, with the interest rate being a function of current and lagged inflation rates and the current and lagged output gap. Such a rule is optimal because current and past inflation rates and output gaps are sufficient statistics for future inflation and demand conditions, which are targeted by the central bank. We show that future demand conditions and CPI inflation in the G7 countries are also determined by the exchange rate and property and share prices. Taking the UK as an example we discuss the implications of this finding for the conduct of monetary policy and show that disregarding asset price movements leads to a sub-optimal outcome for the economy in terms of inflation and output gap variability. This result not only obtains because the information contained in asset prices about future demand conditions is ignored, but also because their omission from the model introduces considerable biases, so that monetary policy would be based on a mis-specified model of the economy. We also show how a Financial Conditions Index (FCI), a weighted average of the short-term real interest rate, the real exchange rate, real property and real share prices can be derived based on the estimated models. The derived FCI appears to be a useful predictor of future CPI inflation.

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Paper provided by Royal Economic Society in its series Royal Economic Society Annual Conference 2002 with number 88.

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Date of creation: 29 Aug 2002
Handle: RePEc:ecj:ac2002:88
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  1. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
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  12. Boris Hofmann, 2001. "The determinants of private sector credit in industrialised countries: do property prices matter?," BIS Working Papers 108, Bank for International Settlements.
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  16. Nicoletta Batini & Kenny Turnbull, 2000. "Monetary Conditions Indices for the UK: A Survey," Discussion Papers 01, Monetary Policy Committee Unit, Bank of England.
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