Financial Asset Prices and Monetary Policy: Theory and Evidence

Frank Smets

No 1751, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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; MCI; Monetary Policy (search for similar items in EconPapers)
JEL-codes: E44 E52 (search for similar items in EconPapers)
Date: 1997-11
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Citations: View citations in EconPapers (94)

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Related works:
Chapter: Financial-asset Prices and Monetary Policy: Theory and Evidence (1997)
Working Paper: Financial asset prices and monetary policy: theory and evidence (1997)
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