Working Paper: CEPR ID: DP3398
Authors: Michael D. Bordo; Olivier Jeanne
Abstract: The link between monetary policy and asset price movements has been of perennial interest to policy makers. In this Paper we consider the potential case for pre-emptive monetary restrictions when asset price reversals can have serious effects on real output. First, we provide some historical background on two famous asset price reversals: the US stock market crash of 1929 and the bursting of the Japanese bubble in 1989. We then present some stylized facts on boom-bust dynamics in stock and property prices in developed economies. We then discuss the case for a pre-emptive monetary policy in the context of a stylized ?Dynamic New Keynesian? framework with collateral constraints in the productive sector. We find that whether such a policy is warranted depends on the economic conditions in a complex, non-linear way. The optimal policy cannot be summarized by a simple policy rule of the type considered in the inflation-targeting literature.
Keywords: asset prices; bubble; credit crunch; monetary policy; new economy; Taylor rule
JEL Codes: E44; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Proactive monetary restrictions may be warranted when asset price reversals threaten to induce a credit crunch (E44) | Serious negative effects on real output (F69) |
| Allowing asset price booms to go unchecked (E32) | Linked to financial instability and reduced economic activity (F65) |
| The risk of a bust increases (E32) | The cost of inaction rises (J17) |
| Historical episodes of asset price reversals illustrate the detrimental impacts of failing to adopt a proactive approach (G18) | Greater output losses compared to a purely reactive monetary policy (E63) |