Credit, asset prices and monetary policy

Abstract

The developments in asset markets have influenced researchersto focus on the interaction between monetary policy and the financial system. In Chapter I we provide an overview of the role of the financial system for the whole economy. We show the importance of this sector in transmitting the monetary policy actions. The aim of this research is twofold; firstly we want to investigate how important the amount of credit for the whole economy is. To accomplish this objective, in Chapter 2 we make use of the VAR technique to study the monetary transmission mechanism. In particular we are interested in explaining why previous empirical research has found that prices show an increase after monetary tightening. We investigate how an unanticipated movement in the risk free interest rate affects all those variables responsible for the transmission of a monetary shock. Our results suggest that the immediate increase in prices is not due to some form of econometric misspecification, but rather, to the change in the composition of firms' source of finance. Prices rise because the need for external funds increases thus firms' costs of production increase. Another important issue that we want to tackle is the contribution of external finance to the 1990 economic recession. In Chapter 3 we show that the increased level of indebtedness as one of the forces at the root of the economic downturn. We argue that the crisis could be explained on the basis of Minsky's financial instability hypothesis. In the remaining part of this research we tackle the second aim of this research: we focus our attention on the link between asset prices and monetary policy. Asset prices, in fact, can give an indication of future consumers' and firms' decisions on spending and, therefore, might be indicators of future economic activity. Wealth deriving from gains in these markets tends t o increase the level of consumption and investment. A t the same time, sharp movements in asset prices could signal imbalances in the economy; developments of this kind can threaten financial stability. In Chapter 4 we argue there might be a trade-off between financial stability and monetary stability when these are the main objectives of the monetary authorities. First we explore the possibility that the demand equation is affected positively by changes in asset prices, secondly empirical findings suggest that for the period 1992: 10-2003: 1 monetary policy in the UK can be better represented by a rule which takes into consideration movements in house prices and stock prices. The empirical evidence provided in Chapter 4 brings us in Chapter 5 to construct a macroeconomic model where the asset prices enter indirectly into the Central Bank's loss function. We model the aggregate demand of the economy so that output is determined, among other variables, by the wealth effect. The optimal interest rate rule is obtained by optimising intertemporally a loss function that includes inflation and output variance. We find that the optimal policy in the presence of wealth effects not only depends upon inflation and output but also it depends on financial imbalances, as represented by asset price misalignments from fundamentals. The response to asset price deviations from fundamentals becomes more aggressive as wealth effects build up, while the reaction to inflation and the output gap becomes less pronounced.