The Role of Monetary Policy in Transmission of Asset Prices into Goods Prices

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.

Economic Factors Influencing Housing Prices in Pakistan

“…Because of these qualities, central banks react to rising house prices more swiftly than stock prices. However, central banks usually respond to asset prices indirectly through their responses to economic activity and inflation [9].…”

“…As a result, state banks respond more quickly to rising housing prices than stock prices. However, state banks respond to asset values indirectly through inflation and economic activity [9].…”

“…Furthermore, in Pakistan, the committee on monetary policy meets every two months, and rarely revises the discount rate. As a result, the discount rate is an ineffective monthly indicator of monetary policy [9]. The data of consumer price index (CPI), the proxy for inflation (INF) and exchange rate (EXR) have been taken from SBP (State bank of Pakistan).…”