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What Should Central Banks Do about Real Estate Prices?

Franklin Allen and Elena Carletti
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Franklin Allen: University of PA
Elena Carletti: European University Institute

Working Papers from University of Pennsylvania, Wharton School, Weiss Center

Abstract: Many central banks use inflation targeting as the basis for their monetary policy. The underlying notion of this approach is that there are no long term benefits in terms of reduced unemployment from having inflation. The traditional view is that monetary policy should focus on controlling consumer price inflation. Asset prices should only be considered in as much as they feed into consumer prices and short term output. However, Reinhart and Rogoff (2009) provide considerable evidence that collapses in real estate prices are the main cause of many financial crises. In this paper we consider how inflation targeting should be adapted to account for real estate prices. We develop a theory of real estate bubbles and show how these can be triggered by low interest rates. It is suggested that in small homogenous countries like Sweden interest rates can be used to prevent bubbles. In large economies this may not be desirable because bubbles tend to be regional. In all economies macroprudential policies have a role to play in preventing and pricking bubbles. However, there is an important issue of how effective they will be in practice.

Date: 2011-01
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