Liquidity and Asset Prices: How Strong are the Linkages

Abstract

Abstract:The appropriate design of monetary policy in integrated financial markets is one of the most challenging areas for central banks. One hot topic is whether the increase in liquidity has contributed to the formation of price bubbles in asset markets in the years preceding the financial crisis. If linkages are strong, the inclusion of asset prices in the monetary policy rule may limit speculative runs and negative spillovers to the real economy in the future. To examine the impacts of liquidity shocks on real share and house prices, VAR models are specified for the US and the euro area, as well as global VARs to control for international feedback. The analysis points to some impact of liquidity shocks on house prices, but the effect is restricted to the US. Stock market prices are not affected. Thus, the results suggest that the link between liquidity and asset prices is fragile and far from being obvious.JEL Classifications: E44, G10, C32, C52

Theory and Practice of Gvar Modelling

“…Dreger and Wolters () investigate the implications of an increase in liquidity in the years preceding the global financial crises on the formation of price bubbles in asset markets. They find that the link between liquidity and asset prices seems fragile and far from being obvious.…”

Theory and Practice of GVAR Modeling

“…Their core macro model is a 2-country version of the GVAR (UK as a small open economy and the US) and they focus on projections for system-wide banking assets in the United Kingdom and show how a combination of extreme credit and trading losses can precipitate widespread defaults and trigger contagious default associated with network e¤ects and …re sales of distressed assets. Dreger and Wolters (2011) investigate the implications of an increase in liquidity in the years preceding the global …nancial crises on the formation of price bubbles in asset markets. They …nd that the link between liquidity and asset prices seems fragile and far from being obvious.…”

Forecasting Housing Approvals in Australia: Do Forecasters Herd?

“…The interaction of house prices and monetary policy is also the subject of the study by Jarociński and Smets (2008). Belke, Orth and Setzer (2008) and Dreger and Wolters (2011) analyse how liquidity affects house prices. Hofmann (2004) and Gerlach and Peng (2005) study the links between bank lending and house prices.…”