Asset Prices, Monetary Policy and Macroeconomic Stability

Abstract

A focal point of macroeconomic policy analysis over the past decade has been whether central banks should respond to changes in asset prices. This thesis addresses the question from the distinct perspective of equilibrium determinacy. By obtaining the conditions for equilibrium determinacy, it is possible to ascertain whether a central bank could induce additional volatility in an economy by adopting a monetary policy rule which incorporates asset prices. This thesis employs a New Keynesian model with a nancial accelerator developed by Bernanke, Gertler and Gilchrist (1999) to analyse the e¤ects on equilibrium determinacy. In contrast to most of the related literature, the principal finding of this thesis is that a central bank can respond to asset prices without inducing additional volatility in the economy. Moreover, responding to asset prices actually decreases the likelihood of indeterminacy. This can be attributed to the substitutability between responding to inflation and asset prices present in a New Keynesian model with a financial accelerator. The key implication is that central banks should take asset prices into account when designing monetary policy.