Inflation Targeting, Asset Prices and Financial Imbalances: Conceptualizing the Debate
This paper attempts to conceptualize the debate regarding the role of asset prices and perceived financial imbalances in the formation of monetary policy from the perspective of theoretically optimal policy responses. While much of the disagreement can be reconciled within the framework of flexible inflation targeting, defined as a commitment to a targeting rule, preemptive policy actions against the build-up of financial imbalances cannot be motivated within such a framework without modification either to the targeting rule or the underlying model. Given standard forecasting models, such actions are shown to be operationally equivalent to targeting financial imbalances explicitly in the central bank loss function.
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aggregate demand appendix asset price movements back to target balance of risk Bank of Thailand bank’s Batini Bernanke Cecchetti characterization of inﬂation coefﬁcient component of asset concern for ﬁnancial concerns about ﬁnancial conditional forecasts context deﬁned deﬁnition difﬁcult discount factor economy Filardo Financial Imbalances ﬁnancial imbalances imploding ﬁnancial instability ﬂexible inﬂation targeting forecast of inﬂation forecasting model formulate policy future given implies incorporate inﬂation and output inﬂation forecast inﬂation targeting central inﬂation targeting framework inﬂuence interest rate setting justiﬁed longer horizons macroeconomic modiﬁcation monetary policy non-fundamental component operationally optimal interest rate optimal policy output and inﬂation output gap output stabilization paper Phillips curve policy actions policy horizon policymakers posed by ﬁnancial prices and ﬁnancial proactive view reaction function real asset returns reﬂects response to asset risk considerations risks of ﬁnancial sufﬁcient Svensson 2003a target variables targeting central bank Taylor rule trade-off transmission mechanism underlying model veriﬁed