Financial Asset Prices and Monetary Policy: Theory and Evidence

CEPR Discussion Paper Series Number 1751

Posted: 27 Feb 1998

See all articles by Frank Smets

Frank Smets

European Central Bank (ECB); KU Leuven - Center for Economic Studies

Multiple version iconThere are 2 versions of this paper

Date Written: November 1997

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.

JEL Classification: E44, E52, G12

Suggested Citation

Smets, Frank, Financial Asset Prices and Monetary Policy: Theory and Evidence (November 1997). CEPR Discussion Paper Series Number 1751, Available at SSRN: https://ssrn.com/abstract=58651

Frank Smets (Contact Author)

European Central Bank (ECB) ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany
+49 69 1344 6550 (Phone)
+49 69 1344 6575 (Fax)

KU Leuven - Center for Economic Studies ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

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