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Optimal Monetary Policy and Asset Price Misalignments

  • Alexandros Kontikas

    (Brunel University)

  • Alberto Montagnoli

    (University of Stirling)

This paper analyses the relationship between monetary policy and asset prices in the context of optimal policy rules. The transmission mechanism is represented by a linearized rational expectations model augmented for the effect of asset prices on aggregate demand. Stabilization objectives are represented by a discounted quadratic loss function penalizing inflation and output gap volatility. Asset prices are allowed to deviate from their intrinsic value since they may be positively affected by past price changes. We find that in the presence of wealth effects and inefficient markets, asset price misalignments from their fundamentals should be included in the optimal interest rate reaction function.

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Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2004 with number 80.

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Date of creation: 17 Sep 2004
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Handle: RePEc:mmf:mmfc04:80
Contact details of provider: Web page: http://www.essex.ac.uk/afm/mmf/index.html

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  1. Jagjit S. Chadha & Lucio Sarno & Giorgio Valente, 2004. "Monetary Policy Rules, Asset Prices, and Exchange Rates," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 529-552, November.
  2. A. Kontonikas & A. Montagnoli, 2002. "Has Monetary Policy Reacted To Asset Price Movements: Evidence From The Uk," Economics and Finance Discussion Papers 02-11, Economics and Finance Section, School of Social Sciences, Brunel University.
  3. Laurence Ball, 1997. "Efficient rules for monetary policy," Reserve Bank of New Zealand Discussion Paper Series G97/3, Reserve Bank of New Zealand.
  4. Charles Bean, 2003. "Asset prices, financial imbalances and monetary policy: are inflation targets enough?," BIS Working Papers 140, Bank for International Settlements.
  5. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  6. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
  7. Conover, C. Mitchell & Jensen, Gerald R. & Johnson, Robert R., 1999. "Monetary environments and international stock returns," Journal of Banking & Finance, Elsevier, vol. 23(9), pages 1357-1381, September.
  8. Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 77-128.
  9. Goodhart, Charles & Hofmann, Boris, 2000. "Financial Variables and the Conduct of Monetary Policy," Working Paper Series 112, Sveriges Riksbank (Central Bank of Sweden).
  10. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May.
  11. Clark, Peter B. & Goodhart, Charles A. E. & Huang, Haizhou, 1999. "Optimal monetary policy rules in a rational expectations model of the Phillips curve," Journal of Monetary Economics, Elsevier, vol. 43(2), pages 497-520, April.
  12. 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.
  13. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  14. Garber, Peter M, 1990. "Famous First Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 35-54, Spring.
  15. Tro Kortian, 1995. "Modern Approaches to Asset Price Formation: A Survey of Recent Theoretical Literature," RBA Research Discussion Papers rdp9501, Reserve Bank of Australia.
  16. Roberts, John M, 1995. "New Keynesian Economics and the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 975-84, November.
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