How should central banks take into account movements in asset prices in the conduct of monetary policy? We provide an analysis to address this issue using a dynamic stochastic general equilibrium model incorporating both price rigidities and financial market imperfections. Our findings are twofold. First, in the presence of these two sources of distortion in the economy, central banks face a policy tradeoff between stabilizing inflation and the output gap. With this tradeoff, central banks could strike a better balance between both objectives if they took variables other than inflation, such as asset prices, into consideration. Second, these benefits decrease when central banks rely on limited information about the underlying sources of asset price movements and cannot judge which part of the observed asset price movements reflects inefficiencies in the economy.
Keywords: asset prices; monetary policy; financial frictions; policy tradeoffs
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.