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