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Should Monetary Policy Respond to Asset Price Misalignments?

  • Alexandros Kontonikas

    (Brunel University)

  • Christos Ioannidis

    (Brunel University)

This paper analyses the relationship between monetary policy and asset prices using a structural rational expectations model that allows for the effect of asset prices on aggregate demand. We assume that asset prices follow a partial adjustment mechanism whereas they are positively affected by past changes, thus allowing for ‘momentum trading’, while at the same time we allow for reversion towards fundamentals. We then conduct stochastic simulations using two alternative monetary policy rules, inflation-forecast targeting and the standard Taylor rule. The results indicate that, under both rules, interest rate setting that takes into account asset price misalignments leads to lower overall macroeconomic volatility, as measured by the postulated loss function of the central bank.

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Paper provided by EconWPA in its series Macroeconomics with number 0404026.

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Length: 24 pages
Date of creation: 26 Apr 2004
Date of revision:
Handle: RePEc:wpa:wuwpma:0404026
Note: Type of Document - pdf; pages: 24
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