Asset Price, Inflation And The Role Of Monetary Policy

Asset price volatility has been a notable characteristic of world economy since1990s. With the development of financial system and asset market, and the excessively increase in monetary aggregate, asset price volatility brings about great challenge for real economy and monetary policy. Beginning with inquiring into the relationship between asset price and inflation, this paper studies the relationship among asset price and some other variables, such as real economy, credit aggregate, and money demand, by combining exploring literature with theoretical analysis, empirical analysis. Furthermore, this paper puts forward some explanation for movement of asset price and inflation, makes deep investigation into monetary policy response to asset price, brings forward policy framework for central bank to respond to asset price.Theoretically, asset price may make great impact on consumption by wealth effect and liquidity effect. The rise of asset price can increase the present value of wealth, improve the liquidity, and make the residents extend consumption. Asset price may make great impact on investment by Tobin q effect, balance sheet effect and confidence effect. The rise of asset price can increase the ratio of market value to resetting cost, improve the balance sheet as well as the value of collateral, and make the enterprises extend investment. With the increase of direct financing ratio and the progress of real estate market, the impact of asset price on consumption and investment should be more and more obvious. Nevertheless, according to empirical evidence from China, it is found that asset price volatility doesn’t make great impact on consumption and investment in the short term; neither does equilibrium relationship exist among asset price, consumption and investment. The transmission mechanism from asset price to aggregate demand maybe does not take effect. At the same time, asset price is a leading variable of inflation rate, which could be the result of some common exogenous shock.There is a very close relation between asset price and credit expansion. Both credit demand and supply could be brought out by asset boom. In the event of asymmetric information and unreasonable acceptance of risk, leveraged investment also leads to interaction of asset price and credit expansion. From the angle of residents, rise of asset price means more wealth, more desire of consumption and investment. Rise of asset price increases the collateral value, which improves the credit acquirability of residents. From the angle of enterprises, rise of asset price means higher market value, more desire of investment and borrowing. Rise of asset price polishes up the corporate balance sheet, which improves the credit acquirability of enterprises. From the angle of banks, it is much easier for banks to raise money from capital market to improve capital adequacy ratio. Risk tolerance and lending ability is also increased. Asset price inflation makes banks improve expectation of profit, so credit supply rises. Furthermore, investors could purchase asset with the money borrowed from banks, by improving leverage. In this channel, higher asset price results in more investors take advantage of leverage. In turn, more money enters asset market which inflates asset price much higher. As a result, higher capital gain could be earned.When the channel of asset price inflation promoting credit expansion is combined with the channel of credit expansion driving asset boom, credit spiral is come into being. Asset price inflation interacts with credit expansion makes the spiral scale up. On the contrary, if credit can not continue to be expanded and asset price stops rising, another credit spiral comes forth. Asset price bursts and credit crashes at once. Crisis is at hand. The economic bubble in Japan, Nordic banking crisis and subprime debt crisis in USA were all accompanied with interaction of credit expansion and asset boom. The empirical analysis shows that interaction of asset price and credit expansion has been in China in the past few years. This paper proves that the mechanism that asset price affects consumption and investment does not exist in practice. Hence the interaction of asset price inflation and credit expansion is actually exterior to real economy, which is mainly caused by unreasonable design of risk acceptance, and investors’taking advantage of leverage. In reality, financial system lags behind the times and financial repression is still serious, so financial capital can not be allocated to real economy smoothly. Development environment for enterprises is not better off and financial supervision system is not perfect, which make much more capital dissociate from real economy, enter financial hoard to inflate asset price. According to empirical analysis, rise of money supply does not cause inflation at the same time. The relationship between money supply and inflation is not as stable as theoretically analyzed. On that basis, this paper puts commodity market and asset market into one research frame for monetary demand. A monetary circle is made up of save, investment, profit and wages among enterprises, financial sectors and residents. Besides monetary circle, there is always some money existing in financial system serving for asset investment and trading, which is financial hoard. The pressure brought by money supply to each market is not balanced. Actual money aggregates is the result of monetary circle integrated with financial hoard. When money supply increases, a couple of combinations for the movement of asset price and inflation may come forth. As a result of price stickiness, response of asset price to money supply more sensitively and decrease in real interest rate, misalignment of monetary demand structure is getting more and more serious. When monetary demand for financial hoard exceeds that for real economy, asset booms more quickly than general price level does. Temporarily, what can be observed is that asset booms as general price level is low and stable. By the time both asset and consumer price are inflated, liquidity has been overflowed. As for China, asset price is also one of the important variables that make great impact on monetary demand. The elasticity of stock price to monetary demand is greater than of inflation, thereby asset inflation is very common along with money supply increase.Since asset boom is the characteristic of overheated economy, leading indicator of inflation and cause of financial instability, it is considered that monetary policy should react to asset price. Some models of how to react to asset boom have been worked out, for example, putting asset price into interest rate reaction function like inflation gap. However, transmission mechanism from asset price to aggregate demand does not work, relationship between asset price stability and general price stability does not necessarily exist. Asset price can make great impact on financial stability in some special way. It is necessary to satisfy some premises and hypotheses if monetary policy tool work. There are some dilemmas and limitations facing with central banks. Raising interest rate with small amplitude can not restrain asset boom. Long term interest rate movement is not sensitive to short term interest rate adjustment. Financial hoard cushioned the effect taken by rise of reserve requirements on deposit. Because that it is difficult to hold policy opportunity and strength, and financial trade affects the true condition of economy, there may be some side effect for real economy when monetary policy reacting to asset price.In view of flaw of monetary policy, this paper explores policy framework of how to deal with asset boom for central bank. On account of China’s practical status, monetary policy should not be used to deal with asset price directly. Asset price can not be included into the measure of inflation. Money supply follows robust rule. Information about asset price volatility is to be collected and unscrambled, in order to improve forward looking of monetary policy. In order to ensure credit enter real economy, financial stability policy should be coordinated with monetary policy and credit supervision should be reinforced. In addition, macroprudential regulation is also an important measure to avoid financial crisis. The whole paper is summed up in the last chapter, as well as the forward research direction.