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Monetary Policy, Asset-price Bubbles and the Zero Lower Bound

  • Tim Robinson

    (Reserve Bank of Australia)

  • Andrew Stone

    (Reserve Bank of Australia)

We use a simple model of a closed economy to study the recommendations of monetary policy-makers attempting to respond optimally to an asset-price bubble whose stochastic properties they understand. We focus on the impact which the zero lower bound (ZLB) on nominal interest rates has on the recommendations of such policy-makers. For a given target inflation rate, we identify several different forms of ‘insurance’ which policy-makers could potentially take out against encountering the ZLB due to the future bursting of a bubble. Even with perfect knowledge of the bubble process, however, which of these will be optimal varies from one type of bubble to another and, for certain bubbles, from one period to the next. It is therefore difficult to draw general conclusions as to whether the ZLB should cause policy-makers to operate policy more tightly or loosely than otherwise, while a bubble is growing – even after abstracting from the informational difficulties they face in practice. We also examine the implications of the ZLB for policy-makers’ preferences as to their inflation target. Policy-makers who wish to avoid concerns about the ZLB should take care not to set too low a target, especially if the neutral real interest rate is low. Such policy-makers should also set a higher target inflation rate if the economy’s natural propensity to rebound from a shock to output is weak, or if output is relatively unresponsive to real interest rate settings.

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File URL: http://www.rba.gov.au/publications/rdp/2005/pdf/rdp2005-04.pdf
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Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp2005-04.

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Date of creation: Jun 2005
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Handle: RePEc:rba:rbardp:rdp2005-04
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  1. Laurence Ball, 1997. "Efficient rules for monetary policy," Reserve Bank of New Zealand Discussion Paper Series G97/3, Reserve Bank of New Zealand.
  2. David Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
  3. Christopher Kent & Philip Lowe, 1997. "Asset-price Bubbles and Monetary Policy," RBA Research Discussion Papers rdp9709, Reserve Bank of Australia.
  4. Coenen Günter & Orphanides Athanasios & Wieland Volker, 2004. "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," The B.E. Journal of Macroeconomics, De Gruyter, vol. 4(1), pages 1-25, February.
  5. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
  6. James Clouse & Dale Henderson & Athanasios Orphanides & David Small & Peter Tinsley, 2000. "Monetary policy when the nominal short-term interest rate is zero," Finance and Economics Discussion Series 2000-51, Board of Governors of the Federal Reserve System (U.S.).
  7. David Gruen & Michael Plumb & Andrew Stone, 2003. "How Should Monetary Policy Respond to Asset-price Bubbles?," RBA Annual Conference Volume, in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy Reserve Bank of Australia.
  8. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
  9. Glenn Rudebusch, 1995. "What are the lags in monetary policy?," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue feb3.
  10. Bennett T. McCallum, 2000. "Theoretical analysis regarding a zero lower bound on nominal interest rates," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 870-935.
  11. Tim Robinson & Andrew Stone, 2005. "Monetary Policy, Asset-price Bubbles and the Zero Lower Bound," RBA Research Discussion Papers rdp2005-04, Reserve Bank of Australia.
  12. Philip Lowe & Claudio Borio, 2002. "Asset prices, financial and monetary stability: exploring the nexus," BIS Working Papers 114, Bank for International Settlements.
  13. Stephen G Cecchetti, 2003. "What the FOMC Says and Does When the Stock Market Booms," RBA Annual Conference Volume, in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy Reserve Bank of Australia.
  14. Laurence Ball, 1994. "What Determines the Sacrifice Ratio?," NBER Chapters, in: Monetary Policy, pages 155-193 National Bureau of Economic Research, Inc.
  15. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
  16. 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.
  17. Mitsuhiro Fukao, 2003. "Financial strains and the zero lower bound: the Japanese experience," BIS Working Papers 141, Bank for International Settlements.
  18. 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.
  19. Marvin Goodfriend, 2000. "Overcoming the zero bound on interest rate policy," Working Paper 00-03, Federal Reserve Bank of Richmond.
  20. Reifschneider, David & Willams, John C, 2000. "Three Lessons for Monetary Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 936-66, November.
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