Working Paper: CEPR ID: DP12937
Authors: Klaus Adam; Michael Woodford
Abstract: We analytically characterize optimal monetary policy for a NewKeynesian model with a housing sector. If one supposes that the private sectorhas rational expectations about future housing prices and inflation, optimalmonetary policy can be characterized without making reference to housing pricedevelopments: commitment to a “target criterion” that refers only to inflation andthe output gap is optimal, as in the standard model without a housingsector. But when a policymaker seeks to choose a policy that is robust to potential departures of privatesector expectations from model-consistent ones, then the optimal target criterionmust also depend on housing prices. In the empirically realistic case wherehousing is subsidized and where monopoly power causes output to fall short ofits optimal level, the robustly optimal target criterion requires the centralbank to “lean against” housing prices: following unexpected housing priceincreases, policy should adopt a stance that is projected to undershoot itsnormal targets for inflation and the output gap, and similarly aim toovershoot those targets in the case of unexpected declines in housing prices.The robustly optimal target criterion does not require that policydistinguish between “fundamental” and “non-fundamental” movements in housingprices.
Keywords: Asset Price Bubbles; Leaning Against the Wind; Inflation Targeting; Optimal Target Criterion
JEL Codes: D81; D84; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimal monetary policy (E63) | Housing prices (R31) |
| Housing price surprises (R31) | Inflation targets (E31) |
| Housing price surprises (R31) | Output gap targets (E23) |
| Monetary policy response to housing prices (E52) | Inflation and output gap (E31) |
| Deviations from rational expectations (D84) | Optimal monetary policy must account for housing prices (E39) |
| Subsidized housing and monopoly power (R31) | Central bank stance (E52) |