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How Do Central Banks React to Wealth Composition and Asset Prices?

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  • Vitor Castro

    () (Faculdade de Economia, Universidade de Coimbra, Portugal / NIPE)

  • Ricardo M. Sousa

    () (University of Minho, NIPE, London School of Economics and FMG)

Abstract

We assess the response of monetary policy to developments in asset markets in the Euro Area, the US and the UK. We estimate the reaction of monetary policy to wealth composition and asset prices using: (i) a linear framework based on a fully simultaneous system approach in a Bayesian environment; and (ii) a nonlinear specification that relies on a smooth transition regression model. The linear framework suggests that wealth composition is indeed important in the formulation of monetary policy. However, the attempts of central banks to mitigate undesirable fluctuations in say, financial wealth, may disrupt housing wealth. A similar result can be found when we assess the reaction of monetary authority to asset prices, although concerns about "price" effects are smaller. The nonlinear model confirms these findings. However, the concerns over wealth and its components are stronger once inflation is under control, i.e. below a certain target. Some disruptions between financial and housing wealth effects are still present. They can also be found in the reaction to asset prices, despite being less intense.

Suggested Citation

  • Vitor Castro & Ricardo M. Sousa, 2010. "How Do Central Banks React to Wealth Composition and Asset Prices?," GEMF Working Papers 2010-19, GEMF, Faculty of Economics, University of Coimbra.
  • Handle: RePEc:gmf:wpaper:2010-19
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    References listed on IDEAS

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    Cited by:

    1. Agnello, Luca & Castro, Vítor & Sousa, Ricardo M., 2012. "How does fiscal policy react to wealth composition and asset prices?," Journal of Macroeconomics, Elsevier, vol. 34(3), pages 874-890.
    2. Dufrénot, Gilles & Khayat, Guillaume A., 2017. "Monetary Policy Switching In The Euro Area And Multiple Steady States: An Empirical Investigation," Macroeconomic Dynamics, Cambridge University Press, vol. 21(05), pages 1175-1188, July.
    3. Agnello, Luca & Castro, Vitor & Sousa, Ricardo M., 2013. "What determines the duration of a fiscal consolidation program?," Journal of International Money and Finance, Elsevier, vol. 37(C), pages 113-134.
    4. Goodness C. Aye & Rangan Gupta & Mampho P. Modise, 2015. "Do Stock Prices Impact Consumption and Interest Rate in South Africa? Evidence from a Time-varying Vector Autoregressive Model," Journal of Emerging Market Finance, Institute for Financial Management and Research, vol. 14(2), pages 176-196, August.
    5. Luca Agnello & Vítor Castro & Ricardo M. Sousa, 2012. "Are there change-points in the likelihood of a fiscal consolidation ending?," NIPE Working Papers 18/2012, NIPE - Universidade do Minho.
    6. Jawadi, Fredj & Soparnot, Richard & Sousa, Ricardo M., 2017. "Assessing financial and housing wealth effects through the lens of a nonlinear framework," Research in International Business and Finance, Elsevier, vol. 39(PB), pages 840-850.
    7. Agnello, Luca & Dufrénot, Gilles & Sousa, Ricardo M., 2013. "Using time-varying transition probabilities in Markov switching processes to adjust US fiscal policy for asset prices," Economic Modelling, Elsevier, vol. 34(C), pages 25-36.
    8. Sushanta Mallick & Ricardo Sousa, 2013. "Commodity Prices, Inflationary Pressures, and Monetary Policy: Evidence from BRICS Economies," Open Economies Review, Springer, vol. 24(4), pages 677-694, September.
    9. Brana, Sophie & Prat, Stéphanie, 2016. "The effects of global excess liquidity on emerging stock market returns: Evidence from a panel threshold model," Economic Modelling, Elsevier, vol. 52(PA), pages 26-34.
    10. Agnello, Luca & Dufrénot, Gilles & Sousa, Ricardo M., 2015. "Nonlinear effects of asset prices on fiscal policy: Evidence from the UK, Italy and Spain," Economic Modelling, Elsevier, vol. 44(C), pages 358-362.
    11. Milas, Costas & Naraidoo, Ruthira, 2012. "Financial conditions and nonlinearities in the European Central Bank (ECB) reaction function: In-sample and out-of-sample assessment," Computational Statistics & Data Analysis, Elsevier, vol. 56(1), pages 173-189, January.
    12. Chatziantoniou, Ioannis & Duffy, David & Filis, George, 2013. "Stock market response to monetary and fiscal policy shocks: Multi-country evidence," Economic Modelling, Elsevier, vol. 30(C), pages 754-769.
    13. Luca Agnello & Ricardo M. Sousa, 2013. "Political, Institutional, and Economic Factors Underlying Deficit Volatility," Review of International Economics, Wiley Blackwell, vol. 21(4), pages 719-732, September.
    14. Zeng, Jhih-Hong & Peng, Chi-Lu & Chen, Ming-Chi & Lee, Chien-Chiang, 2013. "Wealth effects on the housing markets: Do market liquidity and market states matter?," Economic Modelling, Elsevier, vol. 32(C), pages 488-495.
    15. Hammoudeh, Shawkat & Nguyen, Duc Khuong & Sousa, Ricardo M., 2015. "US monetary policy and sectoral commodity prices," Journal of International Money and Finance, Elsevier, vol. 57(C), pages 61-85.
    16. León Navarro, Manuel & Flores de Frutos, Rafael, 2015. "Residential versus financial wealth effects on consumption from a shock in interest rates," Economic Modelling, Elsevier, vol. 49(C), pages 81-90.
    17. Rudan Wang & Bruce Morley & Javier Ordóñez, 2015. "The Taylor Rule, Wealth Effects and the Exchange Rate," Working Papers 2015/08, Economics Department, Universitat Jaume I, Castellón (Spain).
    18. Tsai, I-Chun, 2015. "Dynamic information transfer in the United States housing and stock markets," The North American Journal of Economics and Finance, Elsevier, vol. 34(C), pages 215-230.
    19. Greenwood-Nimmo, Matthew & Tarassow, Artur, 2016. "Monetary shocks, macroprudential shocks and financial stability," Economic Modelling, Elsevier, vol. 56(C), pages 11-24.
    20. Rudan Wang & Bruce Morley & Javier Ordóñez, 2016. "The Taylor Rule, Wealth Effects and the Exchange Rate," Review of International Economics, Wiley Blackwell, vol. 24(2), pages 282-301, May.
    21. Fredj Jawadi & Ricardo M. Sousa, 2012. "Consumption and Wealth in the US, the UK and the Euro Area:A Nonlinear Investigation," NIPE Working Papers 24/2012, NIPE - Universidade do Minho.

    More about this item

    Keywords

    monetary policy rules; wealth composition; asset prices.;

    JEL classification:

    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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