Monetary policy and asset price bubbles: calibrating the monetary policy trade-offs

Working Papers No 155
June 2004
The issue of monetary policy and asset prices has been receiving much attention not only because it is an interesting topic for macroeconomists but also because central banks have faced daunting challenges from large swings in various types of asset prices. To some extent, the achievement of a low, stable inflation environment has not simultaneously brought about a more stable asset price environment. The record over the past decade, in fact, has raised the prospect of asset price booms and busts as a permanent feature of the monetary policy landscape. This paper lays out a general framework to explore some of the key monetary policy trade-offs presented by asset prices, with particular emphasis on the role of asset price bubbles.

The paper first discusses what economists mean by asset price bubbles before putting forward a stylised macroeconomic model in which a monetary authority can influence the behaviour, in only an indirect way, of the path of asset prices. The baseline model suggests that central banks should systematically respond to asset price developments generally and asset price bubbles specifically. Indeed, there are good reasons for the central bank to focus only on asset price bubbles, rather than the fundamental component of asset prices, when calibrating its monetary policy response. This general result does not depend on the volatility of asset prices per se or necessarily on the ability to distinguish fundamental movements in asset prices from asset price bubbles. The paper then introduces a form of uncertainty - intrinsic paradigm uncertainty about the existence of bubbles - to show how policymakers might want to weigh the options of responding or not responding in such an environment. The paper then goes beyond the confines of the model to offer insights about issues such as moral hazard, non-linearities, multivariate bubbles and communication strategies.

Keywords: monetary policy, asset price bubble

JEL classification: E5, G1