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Asset Prices and the Conduct of Monetary Policy

Author

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  • Goodhart, Charles

    (London School of Economics)

  • Boris Hofmann

    (University of Bonn)

Abstract

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.

Suggested Citation

  • Goodhart, Charles & Boris Hofmann, 2002. "Asset Prices and the Conduct of Monetary Policy," Royal Economic Society Annual Conference 2002 88, Royal Economic Society.
  • Handle: RePEc:ecj:ac2002:88
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    References listed on IDEAS

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    Cited by:

    1. Koivu, Tuuli & Mehrotra, Aaron & Nuutilainen, Riikka, 2008. "McCallum rule and Chinese monetary policy," BOFIT Discussion Papers 15/2008, Bank of Finland, Institute for Economies in Transition.
    2. 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, vol. 38(C), pages 392-403.
    3. Rhys ap Gwilym, 2013. "The Monetary Policy Implications of Behavioral Asset Bubbles," Southern Economic Journal, Southern Economic Association, vol. 80(1), pages 252-270, July.
    4. Koivu, Tuuli, 2012. "Monetary policy in transition : Essays on monetary policy transmission mechanism in China," Scientific Monographs, Bank of Finland, number 2012_046, November.
    5. Kasai, Ndahiriwe & Naraidoo, Ruthira, 2011. "Evaluating the forecasting performance of linear and nonlinear monetary policy rules for South Africa," MPRA Paper 40699, University Library of Munich, Germany.
    6. Sajawal Khan & Abdul Qayyum, 2007. "Measures of Monetary Policy Stance : The Case of Pakistan," Macroeconomics Working Papers 22201, East Asian Bureau of Economic Research.
    7. Kirsten Thompson & Renee Van Eyden & Rangan Gupta, 2015. "Identifying an index of financial conditions for South Africa," Studies in Economics and Finance, Emerald Group Publishing, vol. 32(2), pages 256-274, June.
    8. Albulescu, Claudiu Tiberiu, 2008. "Central banks and asset prices: the role of the interest rate in volatility correction in the Romanian case," MPRA Paper 16582, University Library of Munich, Germany, revised 20 Jul 2009.
    9. Castro, Vítor, 2008. "Are Central Banks following a linear or nonlinear (augmented) Taylor rule?," The Warwick Economics Research Paper Series (TWERPS) 872, University of Warwick, Department of Economics.
    10. Nisticò, Salvatore, 2012. "Monetary policy and stock-price dynamics in a DSGE framework," Journal of Macroeconomics, Elsevier, pages 126-146.
    11. 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, pages 228-246.
    12. Kim, J.W. & Leatham, D.J. & Bessler, D.A., 2007. "REITs' dynamics under structural change with unknown break points," Journal of Housing Economics, Elsevier, vol. 16(1), pages 37-58, March.
    13. Francisco Rosende, 2009. "La Macroeconomía y la Crisis: ¿La Crisis de la Macroeconomía?," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 46(134), pages 161-182.
    14. Nisticò, Salvatore, 2012. "Monetary policy and stock-price dynamics in a DSGE framework," Journal of Macroeconomics, Elsevier, pages 126-146.
    15. repec:eco:journ1:2017-04-62 is not listed on IDEAS

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