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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.
  2. Kari H. Eika & Neil R. Ericsson & Ragnar Nymoen, 1996. "Hazards in implementing a monetary conditions index," International Finance Discussion Papers 568, Board of Governors of the Federal Reserve System (U.S.).
  3. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
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  7. N. Gregory Mankiw & David N. Weil, 1988. "The Baby Boom, The Baby Bust, and the Housing Market," NBER Working Papers 2794, National Bureau of Economic Research, Inc.
  8. Marvin Goodfriend, 1990. "Interest rates and the conduct of monetary policy," Working Paper 90-06, Federal Reserve Bank of Richmond.
  9. Kiyotaki, Nobuhiro & Moore, John, 1997. "Credit Cycles," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 211-248, April.
  10. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
  11. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
  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.
  13. Goodhart, Charles, 2001. "What Weight Should Be Given to Asset Prices in the Measurement of Inflation?," Economic Journal, Royal Economic Society, vol. 111(472), pages 335-356, June.
  14. MacDonald, Ronald, 2000. "Concepts to Calculate Equilibrium Exchange Rates: An Overview," Discussion Paper Series 1: Economic Studies 2000,03, Deutsche Bundesbank, Research Centre.
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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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