How Do Central Banks React to Wealth Composition and Asset Prices?

43 Pages Posted: 3 Sep 2010

See all articles by Vitor Castroa

Vitor Castroa

Universidade de Coimbra - Faculty of Economics

Ricardo M. Sousa

University of Minho; Economic Policies Research Unit (NIPE); London School of Economics & Political Science (LSE) - Financial Markets Group; London School of Economics

Date Written: September 2, 2010

Abstract

We assess the response of monetary policy to developments in asset markets in the Euro Area, the US and the UK. We estimate the reaction of monetary policy to wealth composition and asset prices using: (i) a linear framework based on a fully simultaneous system approach in a Bayesian environment; and (ii) a nonlinear specification that relies on a smooth transition regression model.

The linear framework suggests that wealth composition is indeed important in the formulation of monetary policy. However, the attempts of central banks to mitigate undesirable fluctuations in say, financial wealth, may disrupt housing wealth. A similar result can be found when we assess the reaction of monetary authority to asset prices, although concerns about "price" effects are smaller.

The nonlinear model confirms these findings. However, the concerns over wealth and its components are stronger once inflation is under control, i.e. below a certain target. Some disruptions between financial and housing wealth effects are still present. They can also be found in the reaction to asset prices, despite being less intense.

Keywords: monetary policy rules, wealth composition, asset prices.

JEL Classification: E37, E52

Suggested Citation

Castro, Vitor Manuel Alves and Sousa, Ricardo Magalhaes, How Do Central Banks React to Wealth Composition and Asset Prices? (September 2, 2010). Available at SSRN: https://ssrn.com/abstract=1670857 or http://dx.doi.org/10.2139/ssrn.1670857

Vitor Manuel Alves Castro (Contact Author)

Universidade de Coimbra - Faculty of Economics ( email )

Av. Dias da Silva, 165
Coimbra, 3004-512
Portugal
+351-239790526 (Phone)
+351-239403511 (Fax)

Ricardo Magalhaes Sousa

University of Minho ( email )

Campus Gualtar
Braga, 4710-057
Portugal
+351253604584 (Phone)
+351253676375 (Fax)

HOME PAGE: http://www.eeg.uminho.pt/economia/rjsousa

Economic Policies Research Unit (NIPE) ( email )

Campus de Gualtar
Braga, 4710-057
Portugal
+351253604584 (Phone)
+351253676375 (Fax)

HOME PAGE: http://www.eeg.uminho.pt/economia/rjsousa

London School of Economics & Political Science (LSE) - Financial Markets Group ( email )

Houghton Street
London WC2A 2AE
United Kingdom

London School of Economics ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

HOME PAGE: http://econ.lse.ac.uk

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