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Monetary policy responses amid credit and asset booms and busts

  • Pavasuthipaisit, Robert

This paper examines the conduct of monetary policy in the presence of credit and asset booms and busts. Conventional wisdom is for the central bank to respond to asset prices and other financial indicators insofar as these factors affect the forecasts of inflation. This paper finds that such strategy is far from being optimal. This paper derives optimal policy under commitment in a standard financial accelerator model and finds that in the optimal equilibrium, the central bank responds to a rise in productivity growth by making a credible commitment to keep the rate of return on capital below the trend. This causes net worth to be countercyclical, which is the key mechanism that allows the central bank to successfully stabilize the economy. The countercyclicality of net worth is consistent with what can be found in the data on the periods following the Volcker chairmanship of the FOMC.

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File URL: http://mpra.ub.uni-muenchen.de/4491/1/MPRA_paper_4491.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 4491.

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Date of creation: Jun 2007
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Handle: RePEc:pra:mprapa:4491
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  1. repec:cup:macdyn:v:7:y:2003:i:2:p:239-62 is not listed on IDEAS
  2. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers 200106, Rutgers University, Department of Economics.
  3. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
  4. Jinill Kim & Sunghyun Henry Kim, 1999. "Spurious Welfare Reversals in International Business Cycle Models," Virginia Economics Online Papers 319, University of Virginia, Department of Economics.
  5. Tommaso Monacelli & Ester Faia, 2005. "Optimal Interest Rate Rules, Asset Prices and Credit Frictions," Computing in Economics and Finance 2005 452, Society for Computational Economics.
  6. 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.
  7. Sylvain Leduc & Keith Sill, 2006. "Monetary policy, oil shocks, and TFP: accounting for the decline in U.S. volatility," International Finance Discussion Papers 873, Board of Governors of the Federal Reserve System (U.S.).
  8. Bordo, Michael D & Jeanne, Olivier, 2002. "Monetary Policy and Asset Prices: Does 'Benign Neglect' Make Sense?," International Finance, Wiley Blackwell, vol. 5(2), pages 139-64, Summer.
  9. 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.
  10. Julio J. Rotemberg & Michael Woodford, 1998. "Interest-Rate Rules in an Estimated Sticky Price Model," NBER Working Papers 6618, National Bureau of Economic Research, Inc.
  11. Gali, Jordi & Lopez-Salido, J. David & Valles, Javier, 2003. "Technology shocks and monetary policy: assessing the Fed's performance," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 723-743, May.
  12. Levin, Andrew T. & Williams, John C., 2003. "Robust monetary policy with competing reference models," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 945-975, July.
  13. Katharine S. Neiss & Edward Nelson, 2001. "The real interest rate gap as an inflation indicator," Bank of England working papers 130, Bank of England.
  14. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  15. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  16. James H. Stock & Mark W. Watson, 2002. "Has the Business Cycle Changed and Why?," NBER Working Papers 9127, National Bureau of Economic Research, Inc.
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