Monetary Policy and Asset Prices: More Bad News for ‘Benign Neglect’^*

Abstract

In this paper we explore the optimal policy reaction to boom-bust cycles in asset prices. Bordo and Jeanne (2002a, b) point to the risks of a reactive strategy that only mitigates the consequences of a crisis if and when it occurs. Acting pre-emptively by rigorously counteracting the build-up of the crisis scenario may be superior in welfare terms. We show that even a purely reactive monetary policy must involve an ex ante response to a possible asset price crash. The reason, however, is not the attempt to avoid real and financial disruption but to react optimally to changes in the private sector's expectations. Furthermore, we find that the welfare losses of a reactive strategy increase when forward-looking expectations are taken into account, while the welfare implications of a proactive strategy do not change.

The Yield Curve and Financial Risk Premia

“…This proactive, pre-emptive view relies on the premise that the duration of imbalances heighten the risk of sudden reversals. act as insurance against asset price reversals at the costs of short-term output losses (Berger et al 2007). While the debate in the early 2000s has concentrated (solely) on asset price bubbles, risk-taking mechanisms focus on the market-based financial system as a whole.…”

Monetary policy and asset prices: When cleaning up hits the zero lower bound

“…In addition, the lower household indebtedness, the lower is the probability that a bust in the collateral value of houses will lead to a credit crunch that reduces households' refinancing options. 11 12 A similar approach is chosen by Berger et al (2007) and Kissmer (2008, 2009) in related models. 13 The model is solved by backward induction.…”

“…Then the results for the first two periods can be derived. 14 For example, see the discussion in Berger et al (2007).…”

“…149 (3) 23 As explained above, interest rate moves can affect both household leverage and consumption directly, through the change in cost and availability of credit, and indirectly, by influencing house prices (see, e.g., IMF 2008). In contrast with our focus on household indebtedness, Bordo and Jeanne (2002), Berger et al (2007) and Kissmer (2008, 2009) analyze the optimal monetary reaction to asset price booms by incorporating the idea that policymakers' interest rate policy may affect non-financial corporate indebtedness, while Woodford (2012) focuses on the nexus between interest rate policy and the leverage of the financial sector.…”

The causes of the recent financial crisis and the role of central banks in avoiding the next one

“…The present author favours conducting such research along the lines ofBordo and Jeanne (2002),Berger, Kißmer and Wagner (2007), and Wagner (2008, 2010).…”