Volume 4, Issue 4 December 2008

Monetary Policy under Uncertainty about the Nature of Asset-Price Shocks

Abstract

The effects of an asset-price movement on inflation and output depend on whether that movement is fundamental or not. However, central banks cannot observe this. This paper examines the issue of how central banks should respond to asset prices given this constraint. Using a modified version of the Gruen, Plumb, and Stone (2005) model, this paper finds it is better to adopt a three-standard-deviation threshold rule for deciding whether to include asset prices in output-gap and inflation forecasts and monetary policy than to ignore asset prices altogether.