Working Paper: NBER ID: w12442
Authors: Simon Gilchrist; Masashi Saito
Abstract: This paper studies the implications of financial market imperfections represented by a countercyclical external finance premium and the gradual recognition of changes in the drift of technology growth for the design of an interest rate rule. Asset price movements induced by changes in trend growth influence balance-sheet conditions that determine the external finance premium. Such movements are magnified when the private sector is imperfectly informed regarding the trend growth rate of technology. The presence of financial market imperfections provides a motivation for responding to the gap between the observed asset prices and the potential level of asset prices in addition to responding strongly to inflation. This is because the asset price gap represents distortions in the resource allocation induced by financial market imperfections more distinctly than inflation. The policymaker's imperfect information about the drift of technology growth renders imprecise the calculation of the potential and thus reduces the benefit of responding to the asset price gap. A policy that responds to the level of asset prices which does not take into account changes in potential tends to be welfare reducing.
Keywords: monetary policy; asset prices; financial market imperfections; learning; external finance premium
JEL Codes: E44; E52; O41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Asset Price Movements (G19) | Economic Activity (R11) |
| Economic Activity (R11) | Output (Y10) |
| Economic Activity (R11) | Inflation (E31) |
| Asset Price Movements (G19) | External Finance Premium (G19) |
| External Finance Premium (G19) | Investment Demand (E22) |
| Investment Demand (E22) | Economic Activity (R11) |
| Monetary Policy Response to Asset Price Gap (E44) | Economic Outcomes (P47) |
| Private Sector Informed about Technology Growth (O39) | Economic Outcomes (P47) |