Asset Price Fluctuation And Monetary Policy Optimal Response In China

Monetary policy is an important tool for the central bank to promote stablemacroeconomic growth. In the past three decades, central bankers, governments andeconomists have reached a consensus that price stability should be the first goal for thecentral bank. However, in recent years, price volatility and the bubble burst, frequentlycause the financial crisis, which challenges the monetary policy at this stage. Especially after the subprime crisis, the theorists oppugn the consensus and also payattention to the problem whether monetary policy makes response to asset priceWhether central banks choose symmetric or asymmetric monetary policy torespond to asset price yet is not determined. there are usually two views, one is "benignneglect”,that the central bank does not respond to the asset prices, and just waits untilthe bubble burst,then cleans up the mess by injecting liquidity to the market or othermeasures. Another is the "leaning against the wind”. which is that when the asset priceis inflated, the central bank raises interest rate to control the asset price bubble, in orderto prevent asset price bubble’s bursting and the long-term deflation risk. But there isno conclusion that which one of them is better. After the subprime crisis, the issueattracts the attention of economists and central bankers again.This paper introduces the financial condition index as a proxy variable of assetprices. First of all, the paper explains the mechanism between the asset price and thegoals of the central bank and the effect of the response of the monetary policy to assetprices. Then we design financial conditions index, and introduce it as a proxy variableof asset prices into a New Keynesian four-equation model for the empirical analyzingin this article. By it, we extend the model and make a simulation analysis in twodifferent cases. one is that the model does not include asset prices,the other is that themodel includes the asset price as a response function term. Then we get the analogvalue of the inflation gap and the output gap, and take them into the central bank lossfunction to judge that which model is better. Then we will get the conclusion to theproblem that the optimal monetary policy should respond to the asset price. Finally,according to the research conclusions we will give our own suggestions. This article points out that under the premise that the current macro-prudentialpolicy framework has not been perfect, the monetary policy response to the asset pricesis the optimal choice of settling the asset price bubble problem, the central bankshould monitor the asset prices, and make timely adjustment of asset prices, to preventthe expansion of the asset price bubble. First of all, considering the relationshipbetween asset prices and monetary policy framework, the volatility of asset prices willaffect the price stability goal from the two channels of the current demand andexpectations of future price. And the bursting of the asset price bubble can bring hugesystemic risk, spoil the financial stability and trigger the financial crisis, by the microcredit expansion mechanism in the Allen and Gale (2000) and the financial acceleratormechanism.In addition, asset prices will also make the monetary policy transmissionmechanism complicated. Therefore, the central bank must make a deal with asset pricevolatility, take asset prices into the monetary policy framework in order to find theoptimal monetary policy strategy.In this paper, we use a forward-looking New Keynesian model and financialconditions index introduced into the model as a proxy variable.after that, we make asimulation analysis on the asset prices and monetary policy. and find that under thepure inflation targeting, the optimal measure is that monetary policy does not respondsto the asset price; but if monetary authorities consider the trade-off between theoutput and inflation target,the monetary policy response to the asset prices is optimal.Considering that Chinese monetary policy objectives are the stability of the currencyand steady economic growth, China’s monetary authorities should pay attention to therole of the asset price fluctuation in the monetary policy.