Working Paper: CEPR ID: DP1751
Authors: Frank Smets
Abstract: The work presented in this paper falls into two parts. First, using a simple model and within the context of the central bank?s objective of price stability, it is shown that the optimal monetary response to unexpected changes in asset prices depends on how these changes affect the central bank?s inflation forecast, which in turn depends on two factors: the role of the asset price in the transmission mechanism and the typical information content of innovations in the asset price. In this context, the advantages and disadvantages of setting monetary policy in terms of a weighted average of a short-term interest rate and an asset price such as the exchange rate ? a Monetary Conditions Index (MCI) ? are discussed. The second, more empirical, part of the paper, uses an estimated policy reaction function, to document the short-term response to financial asset prices, including the exchange rate, in two countries with inflation targets (Australia and Canada) and suggests that the different response to exchange rate changes in these countries can in part be explained by differences in their underlying sources.
Keywords: asset prices; monetary policy; monetary conditions index
JEL Codes: E44; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Asset Price Movements (G19) | Inflation Forecasts (E31) |
| Inflation Forecasts (E31) | Central Bank Policy Response (E52) |
| Asset Price Movements (G19) | Central Bank Policy Response (E52) |
| Optimal Response to Asset Prices (G19) | Information Content of Asset Prices (G19) |
| Exchange Rate Shocks (F31) | Central Bank Policy Decisions (E52) |
| Real or Financial Source of Exchange Rate Shocks (F31) | Central Bank Policy Decisions (E52) |