Monetary Policy and Asset Prices: The Impact of Globalization on Monetary Policy Trade-Offs

Abstract

This paper studies the nexus between globalization and the optimal monetary policy response to asset prices. Employing a modified New Keynesian sticky price model we explore how the slope of the Phillips curve influences the monetary policy trade-offs that policymakers face in the presence of boom-bust cycles in asset markets. Basically, policymakers can choose between a pro-active policy that raises short term real interest rates during an asset price boom to prevent the build-up of a financial market crisis scenario and a reactive policy that ignores its impact on the likelihood of a future crisis. We show that a globalization-induced flattening of the Phillips curve raises the maximum level of the real interest rate that central bankers are willing to endure in order to avoid a future financial market crisis. Thus, globalization makes the pro-active strategy a more favorable policy option.

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