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Asset Prices, Financial Conditions, and the Transmission of Monetary Policy

A Monetary Conditions Index (MCI), a weighted average of the short-term interest rate and the exchange rate, has commonly been used, at least in open economies, as a composite measure of the stance of monetary policy. The MCI concept was based on empirical findings that inflationary pressures are determined by excess aggregate demand and that monetary policy mainly affects aggregate demand via its leverage over short-term interest rates and the real exchange rate.

Changes in the stance of monetary policy affect short-term money market interest rates, which in turn influence the investment and saving decisions of households and firms and thus domestic demand conditions. A change in short-term interest rates changes, ceteris paribus, the interest rate differential vis-à vis the rest of the world and may thus lead to a change in the real exchange rate, which in turn affects the competitiveness of domestic firms vis-à-vis foreign firms and thus external demand conditions.

Recent developments in theoretical and empirical research on the monetary transmission process imply that property and equity prices may also play an important role in the transmission of monetary policy via wealth and balance sheet effects. Monetary policy can affect property and equity prices via arbitrage effects and/or a change in discounted expected future dividends, which gives rise to the wealth effect and the balance sheet effect of monetary policy.

A wealth effect may arise because a change in asset prices affects the financial wealth of consumers, which may induce them to change their consumption plans (Modigliani, 1971). The strength of the wealth effect of a change in asset prices depends in part on the share of the respective asset in private sector wealth. Table 1 shows the composition of household wealth in the G7 countries in 1998. In all countries, maybe except for Japan, housing assets account for a substantial share in household wealth. Equity accounts for a lower share than housing assets throughout, but there are significant differences across countries. The share of equity in household wealth is considerable in the US, Italy, the UK and Canada, but negligible in Japan, Germany and France.

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Asset Prices, Financial Conditions, and the Transmission of Monetary Policy