Expectations, Asset Prices, and Monetary Policy

Abstract

This chapter considers the design of monetary policy rule in an environment where both the private sector and the monetary authority learn about the trend growth rate of technology. In the presence of financial market imperfections resulting from asymmetric information between lenders and borrowers, shocks to the economy that cause increases in asset prices improve the balance-sheet conditions of borrowers, reduce the external finance premium, and amplify the response of real economic activity. This amplification mechanism—the financial accelerator mechanism—represents a distortion in underlying economic activity that can only partially be eliminated by a policy of responding strongly to inflation. It is also shown that the overall gains from allowing the monetary authority to respond to the asset price gap are greatest when the monetary authority can correctly identify the true state of technology growth, while the private sector must infer it from past observations of technology growth.

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