Should monetary policy respond to asset price misalignments

Kontonikas, A and Ioannidis, Christos (2005). Should monetary policy respond to asset price misalignments. Economic Modelling, 22 (6), pp. 1105-1121.

Abstract

This paper analyses the relationship between monetary policy and asset prices using a structural rational expectations open economy model that allows for the effect of asset prices and exchange rates on aggregate demand. We assume that asset prices and exchange rates follow a partial adjustment mechanism whereas they are positively affected by past changes, thus allowing for ‘momentum trading’, while at the same time we allow for reversion towards fundamentals. We then conduct stochastic simulations using two alternative monetary policy rules, inflation-forecast targeting and the standard Taylor rule. The results indicate that, under both rules, interest rate setting that takes into account asset price misalignments leads to lower overall macroeconomic volatility, as measured by the postulated loss function of the central bank.

Publication DOI: https://doi.org/10.1016/j.econmod.2005.07.004
Divisions: Aston Business School
Additional Information: © 2005, Elsevier. Licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International http://creativecommons.org/licenses/by-nc-nd/4.0/
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Related URLs: https://www.sci ... 264999305000623 (Publisher URL)
Published Date: 2005
Authors: Kontonikas, A
Ioannidis, Christos

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