Tuesday, November 24, 2009

Optimal Monetary Policy during Endogenous Housing-Market Boom-Bust Cycles

This paper uses a small-open economy model for the Canadian economy to examine the optimal Taylor-type monetary policy rule that stabilizes output and inflation in an environment where endogenous boom-bust cycles in house prices can occur.

The model shows that boom-bust cycles in house prices emerge when credit-constrained mortgage borrowers expect that future house prices will rise and this expectation is neither shared by savers nor realized ex-post. These boom-bust cycles replicate the stylized features of housing-market boom-bust cycles in industrialized countries. In an environment where mortgage borrowers are occasionally over-optimistic, the central bank should be less responsive to inflation, more responsive to output, and slower to adjust the nominal policy interest rate.

This optimal monetary policy rule dampens endogenous boom-bust cycles in house prices, but prolongs inflation target horizons due to weak policy reactions to inflation fluctuations after fundamental shocks.

5 comments:

Ross said...

This ignores the fact that inflation has only one source, the government. Their the ones who print the money and run the deficits that create inflation in the first place. So to understand this Taylor rule you have to first put the cart infront of the horse. Works when you are going down hill but at the zero bound it stops working. The Fed recently said that the taylor rule shows that interest rates sould now be negative.
Interesting times. (pun intended)

ValueMonkey said...

This ignores the fact that inflation has only one source, the government.

Central banks, like the one in Canada, are independent from the government. The central bank lends cash to the government. The government sets the budget and potentially runs a deficit. So there are two political entities, not one.

If you still think they work as one, check out this recent story on the Bank of Japan versus the Government of Japan (http://business.timesonline.co.uk/tol/business/economics/article6926003.ece).

Ross said...

When I say government I meant all the branches of the governemnt, not just the elected representatives. Of course there are independant branches like the Bank of Canada and the courts but, they are still part of the government. Sorry if this lead to any confusion.

Ross said...

I also include crown corporations as part of the government, Canada Post, the Bank of Canada and C.B.C. etc.

ValueMonkey said...

Ok, but I still don't agree with your point.

This ignores the fact that inflation has only one source ...

You can argue that hyperinflation is caused by uncontrolled growth in money supply, but regular inflation is typically attributed to changes in supply/demand dynamics. Certainly these changes are not controlled by any one or two political entities.