Monetary Policy and Asset Prices : How do Boom-Bust Cycles influence the optimal strategy of Monetary Policy?
In this dissertation, a very important issue for both policymakers and researchers is analyzed. Should monetary policy respond to boom-bust cycles in asset prices, and how should it respond? Should monetary policymakers adopt a proactive policy that raises short-term real interest rates during an asset price boom to prevent the build-up to a financial market crisis, or should they follow a reactive policy that ignores its impact on the likelihood of a future downward financial cascade? A preemptive interest rate hike may involve unnecessary, high welfare losses in terms of too low inflation and output losses during the boom-phase, while a reactive strategy may be associated with a bust-induced economic recession in the aftermath of the boom. Recently, the subprime and financial crisis of 2007-2009 that evolved to a worldwide economic crisis has once again brought focus to this policy question. The focus of this dissertation is on the influence of boom-bust cycles in asset prices on the optimal strategy of monetary policy. In this regard, the optimal strategy of monetary policy is defined as the combination of optimal monetary policy and the communication of optimal monetary policy. This focus determines the structure of the dissertation, with the main part dedicated to optimal monetary policy (in chapters 2, 3 and 4) and a further part dedicated to central bank communication (in chapter 5). In chapter 2, an introduction to monetary policy and asset prices is given, providing definitions and giving an overview of the transmission mechanism, empirical evidence and the development of model classes regarding boom-bust cycles in asset prices. Furthermore, a literature review regarding the topic of whether and how monetary policy should consider asset price developments is delivered. Following the classic discussion of Bernanke and Gertler (1999), (2001) and Cecchetti et al. (2000) and (2003), models that are characterized by focusing on non-linear asset price developments and their consequences for economic objectives are introduced. These models do not explicitly focus on asset price bubbles and do not integrate asset prices in Taylor rules. Rather, they allow for the consequences of asset price developments and credit growth, for example a credit crunch. Main proponents of this approach are Bordo and Jeanne (2002a, b). They conclude that the desirability of a proactive policy depends in a complex way on economic conditions. It is therefore not easy to obtain a simple policy rule for acting proactively. Rather, the central bank has to weigh the trade-off of immediate losses today when using a proactive strategy in order to prevent a credit crunch by raising interest rates and possible losses in the future due to a credit crunch with decreasing output and increasing inflation. Extending the analysis of Bordo and Jeanne (2002a, b), Berger, Kißmer and Wagner (2007) present an interesting approach regarding the distinction between the reactive and the proactive strategies. The framework of Bordo and Jeanne (2002a, b) and Berger, Kißmer and Wagner (2007) lies at the very heart of the innovative part of this dissertation. Their framework is used since it is a development compared to the classic discussion and manages to integrate financial developments in a realistic way: they focus not only on asset price bubbles but also on indicators signaling possible (future) asset price misalignments. As is shown in this dissertation, it is very important that money, credit growth, and private debt be taken into account, measures that have been neglected in the run-up phase to several boom-bust cycles of the recent past. In the framework of chapters 3.5, 4 and 5, this finding is implicitly reflected in the assumption of a possible credit crunch due to an asset price bust and an overly large debt of some financial market participants. This work is primarily theoretical in its contributions, though it is complemented by numerical simulations based on empirical research. In chapter 3, the basic model for analyzing the optimal monetary policy, the New Keynesian model, is introduced. Furthermore, the caveats of this model class are illustrated and, in chapters 3.3, 3.4 and 3.5, proposals for a development towards a more realistic modeling are presented. In chapter 3.5, the basic New Keynesian model with several extensions, including the consideration of financial developments, is introduced. It is shown that monetary policy during boom-bust cycles faces a trade-off between a proactive policy of curbing asset price inflation and preventing a bust-induced credit crunch and, on the other side, a reactive policy of loosening monetary policy conditions during the boom phase. Using this model in chapter 4, the recent developments towards a higher integration of financial and goods markets (commonly called globalization) are introduced and their impact on the optimal monetary policy in the face of boom-bust cycles is analyzed. In this dissertation, globalization is considered to be a flattening of the Phillips curve and, in chapter 4.3, a flattening of the demand curve. Since the flattening of the Phillips curve is the more important and apparent feature, it is analyzed at length in chapter 4.1. In chapter 4.2, the model of chapter 3.5 is enhanced by including globalization in the form of a flatter Phillips curve and it is shown that this extension has an clear-cut impact on the question of whether central bankers should behave pro- or reactively: a flatter Phillips curve is associated with smaller losses for the proactive strategy and, hence, favors the proactive policy stance. In chapter 4.3, the model is extended in order to explicitly analyze a small open economy. Here, globalization is captured by an increase in the degree of openness. This induces a flattening of the Phillips curve and, in addition, a flattening of the demand curve. Analyzing the policy trade-offs for central bankers and considering the proactive and the reactive strategy, it is shown that there is no unambiguous analytical result. However, using a numerical simulation, it turns out that the reactive strategy of loosening monetary policy conditions in the boom period is the optimal choice in all cases of parameter variation, when both strategies are compared in a relative way. Only when employing an absolute comparison of both strategies (comparing losses) and in very exceptional situations, the proactive strategy is the favored monetary policy. In chapter 4.4, an alternative channel of globalization is considered, the elasticity of substitution between home and foreign goods. Although the exact effect of globalization on this elasticity is ambiguous, when assuming that globalization and the elasticity of globalization are positively correlated, the results of chapter 4.3 are confirmed. The second part of the optimal strategy of monetary policy, central bank communication, is analyzed in detail in chapter 5. It is analyzed which impact communication might have on the policy trade-off between the proactive and reactive strategy. It is shown that central bank communication might work as a second (complementary) instrument of monetary policy during boom-bust cycles. Here, it is argued that central banks could combine the communication about their future policy (interest rate) path with possible actions regarding asset price misalignments. In this regard, being transparent about the future policy path enables central banks to steer the behavior of financial markets in the case of boom-bust cycles. Therefore, when policymakers announce interest rate increases due to excessive credit growth, financial markets might adjust their behavior. Against the background of the discussion regarding another instrument during or before boom-bust cycles, it is argued that policymakers should focus on the core instruments of monetary policy: the interest rate and the central bank communication. In a modified New Keynesian model, the focus is on the situation for central bankers during the boom period. They can choose between the proactive strategy of curbing asset price inflation and the reactive strategy of loosening monetary conditions during the boom period. It is shown that the additional use of this communication channel broadens the scope for the proactive strategy because it decreases the ‘insurance premium’ of this policy choice and therefore its losses. In chapter 6, an outlook regarding further research, caveats of the presented work and possible improvements are presented. Chapter 7 concludes.
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