The Role of Asset Prices in Best-Practice Monetary Policy

I study the role of asset prices in the conduct of monetary policy under the commitment equilibrium. The findings lend support to the lean-against-the-wind strategy in that it is optimal for the central bank to set interest rates to respond to asset-price movements. The gain from responding to asset prices comes from the fact that asset-price movements can provide a signal about the development in the state of the economy. The paper also suggests that prior to and during the subprime mortgage crisis of 2007, it would have been optimal for the Federal Reserve to increase the weight of asset prices in its rate-setting decision.