Asset Prices and Monetary Policy in the Euro Area: a tentative model

The nature of the relationship between asset price movements and monetary policy is a currently hotly debated topic in macroeconomics. This paper examines empirically if monetary policy in the euro-area, since 1987, has been influenced by high valuations of the equity and housing markets. A first aim of the paper is to assess the performance of Taylor-type rules and to evaluate whether alternative specifications, including asset prices, can better track the interest rate setting in the euro area. The general finding is that a Taylor-like rule, with an interest rate smoothing term but without including asset prices, seems to be helpful in describing monetary policy in the euro-area in the last fifteen years. Next, in the context of a simple macro model, extended with asset prices, we derive the optimal reaction function for the monetary authorities. Through a simple calibration of that model, we find that asset prices inclusion in the monetary authority’s reaction function implies a larger volatility for the interest rate and destabilizes the economy. That is, apart from demand shocks, the rule incorporating asset prices implies more volatility than a simple rule. The effect of the disturbances dies out after some periods, but the observed volatility in the variables is greater in the extended model.