Abstract
Monetary policy in the contemporary world reacts, through short term interest rate, to deviations of inflation rate and output from their respective targets, while asset prices are responded to the extent they contribute to these deviations. This practice significantly affects transmission of asset prices into goods prices, which has serious implications for income distribution. This paper sets the objectives of estimating transmission of asset prices into goods prices and the role of monetary policy in influencing this transmission. In this regard, the paper hypothesizes that inflation rate positively responds to asset prices and this response weakens if interest rate leans against the winds of inflation, output and asset prices. To test these hypotheses, we have estimated different specifications of vector autoregressive (VAR) model and impulse response functions have been found after identifying structural shocks. Data of Pakistan’s economy on inflation rate, large scale manufacturing index, interest rate and asset price index – comprising house prices, stock prices and exchange rate – are used for the time period 2000m01 to 2019m06. We find evidence in support of both hypotheses; asset price inflation positively transmits into goods price inflation and this transmission intensifies if interest rate does not respond to other variables in the model. Moreover, transmission of asset prices into inflation rate, as compared to output, is influenced more by monetary policy. Finally, we find that the transmission of exchange rate and house prices to inflation rate are very much affected by monetary policy while in case of stock prices the influence of policy is moderate.
Highlights
The quantitative strength of asset price channel in the transmission of monetary policy depends on how much policy affects asset prices and the contribution these prices make in shaping the target variables – inflation rate and output
We find evidence in support of both hypotheses; asset price inflation positively transmits into goods price inflation and this transmission intensifies if interest rate does not respond to other variables in the model
We find that the transmission of exchange rate and house prices to inflation rate are very much affected by monetary policy while in case of stock prices the influence of policy is moderate
Summary
The quantitative strength of asset price channel in the transmission of monetary policy depends on how much policy affects asset prices and the contribution these prices make in shaping the target variables – inflation rate and output. Most of the studies like Goodhart and Hofmann (1998), Bernanke and Gertler (1999), Filardo (2001), Issing (2003), and Svensson (2011) argue for indirect response of monetary policy to asset prices; central banks react to changes in asset prices when these are reflected in goods price inflation (or inflation forecast), which is a target variable in policy reaction function. This recommendation is practiced by most of the central banks
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