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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. 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.
  2. Charles Bean, 2003. "Asset Prices, Financial Imbalances and Monetary Policy: Are Inflation Targets Enough?," RBA Annual Conference Volume, in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy Reserve Bank of Australia.
  3. 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.
  4. Michael Woodford, 2001. "The Taylor Rule and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 91(2), pages 232-237, May.
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  6. Laurence Ball, 1997. "Efficient rules for monetary policy," Reserve Bank of New Zealand Discussion Paper Series G97/3, Reserve Bank of New Zealand.
  7. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  8. Goodhart, Charles & Hofmann, Boris, 2000. "Financial Variables and the Conduct of Monetary Policy," Working Paper Series 112, Sveriges Riksbank (Central Bank of Sweden).
  9. Garber, Peter M, 1990. "Famous First Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 35-54, Spring.
  10. 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.
  11. Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
  12. Michael D. Bordo & Olivier Jeanne, 2002. "Boom-Busts in Asset Prices, Economic Instability, and Monetary Policy," NBER Working Papers 8966, National Bureau of Economic Research, Inc.
  13. Chadha, Jagjit S & Sarno, Lucio & Valente, Giorgio, 2003. "Monetary Policy Rules, Asset Prices and Exchange Rates," CEPR Discussion Papers 4114, C.E.P.R. Discussion Papers.
  14. Tro Kortian, 1995. "Modern Approaches to Asset Price Formation: A Survey of Recent Theoretical Literature," RBA Research Discussion Papers rdp9501, Reserve Bank of Australia.
  15. A. Kontonikas & A. Montagnoli, 2002. "Has Monetary Policy Reacted To Asset Price Movements: Evidence From The Uk," Public Policy Discussion Papers 02-11, Economics and Finance Section, School of Social Sciences, Brunel University.
  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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