Asset price volatility and monetary policy rules: A dynamic model and empirical evidence

A dynamic model is set up to explore monetary policy in the presence of asset price volatility. If the probability for the asset price to increase or decrease in the next period is taken as an exogenous variable, the monetary policy rule turns out to be a linear function of state variables. We also explore a monetary policy rule assuming that the probability for the asset price to decrease or increase can be affected by monetary policy and asset price bubbles, and find that a state-dependent monetary policy rule might arise. We further consider monetary policy with asset prices in the presence of a zero-interest-rate bound. Our study shows that a financial market depression can make a deflation and an economic recession worse, implying that policy actions aiming at escaping a liquidity trap should not ignore asset prices.