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1. Introduction
Asset prices across different regions and markets experienced large movements before and during the recent global financial and Eurozone crisis. Being a critical component in the economic and financial system, these asset price fluctuations have attracted a lot of attention from academia and practitioners. Monetary policy has been frequently identified as a major driver of asset price booms and busts as well as an instrument to mitigate the possibly severe consequences on economic and financial stability.
The literature on the transmission mechanism of monetary policy to asset price dynamics is extensive. The mainstream view, focusing on the effect of liquidity, has its roots in the theories of Keynes and was essentially coined by Monetarist economists. Friedman (1970), well known for his statement1 “inflation is always and everywhere a monetary phenomenon”, argues that changes in the quantity of money
have a dominant impact on nominal income, prices and output. Thereby, the effect of a change in the rate of change in the quantity of money first shows up in nominal income then in output followed by a lagged effect on inflation. The transmission of the monetary change to the nominal income involves portfolio adjustment and change in relative prices, which have a direct impact on asset prices (Friedman, 1970;
Friedman & Schwartz, 1965).
Following the monetarist theory, a monetary policy induced rise in the quantity of money increases the amount of cash people and businesses have relative to other assets. The excessive cash is used to adjust their portfolios by buying existing assets such as bonds, equities, real estate, and other physical capital. As one man’s spending
1 In this context, Friedman (1970) understands monetary phenomenon as an increase in the quantity of money that exceeds output. The effect on how the general price level is affected by the increase of the quantity of money, however, is not a direct one; it is rather part of the process how monetary changes are transmitted to economic changes.
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is another man’s receipt and market participants attempt to change their cash balance, the effect spreads from one asset to another. In this regard, Tobin (1969) illustrates the mechanism how monetary changes impact different asset classes. Accordingly, an increase in the supply of any asset alters the structure of rates of return on this and other assets so that it induces market participants to hold the new supply. If the rate of the asset is fixed, as in the case of money, the adjustment process works through reductions in other rates or increases the price of other assets. A substitution from assets with high return towards assets with lower returns is carried out as returns on the former decline relative to the latter. The portfolio adjustment not only tends to increase prices of assets across different categories but also reduces interest rates. The positive price effect on assets paired with the negative effect on interest rates in turn encourages spending to produce new assets and gives an incentive for spending on current services rather than buying existing assets. Through this process the initial effect on portfolio adjustment translates into an effect on income and spending. In a later stage, as spending and price inflation move up, demand for loans as well as discrepancy between real and nominal interest rates increases, leading to an upward movement of the interest rate later on.
An alternative view on the relationship between monetary policy and asset prices is provided by the Austrian business cycle theory developed by Mises (1912) and Hayek (1935). The theory has been carried forward to the modern discussion on asset price booms (Bordo & Landon-Lane, 2013; Bordo & Wheelock, 2004) and incorporated in the BIS view (Borio, 2012; Borio, English, & Filardo, 2003; Borio & Lowe, 2002). In contrast to the monetarist view (Friedman, 1970) which regards the quantity of money as the key element of monetary policy in the context of asset price dynamics, the Austrian view pays special attention to interest rates and credit. In this view, changes
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in interest rates are not merely side effects of portfolio adjustment and of changes in relative prices triggered by an increase in the quantity of money, but rather a key element driving asset prices and entire business cycles.
The Austrian business cycle theory argues that an increase in money supply lowers interest rates below its natural rate2, inducing a credit-financed investment boom which bids up prices of capital goods relative to consumption goods. Thereby, prices of capital goods rise faster than consumption goods because entrepreneurs spend the increased amount of money loaned by banks on capital goods. While prices of capital goods rise first, prices of consumption goods rise only moderately at the rate as they are increased by money loaned by consumption goods. Soon after, as the loan rate rises and approaches the natural rate, the movement reverts and prices of consumption goods rise while prices of capital goods decline. This reverse movement can be temporarily countered by monetary intervention which increases money supply and holds interest rates below the natural rate. The reason why credit is channeled into capital goods after a drop of the interest rate below its natural rate is because interest rates play an important role in the economy as a coordinator of investment and production across time. When consumers prefer to consume in the future rather than today, they will increase savings; this in turn will lead to an interest rate decline, giving producers a signal to engage in capital-intensive investments and sell their products in the future. The reverse holds true when consumers prefer to consume today rather than in the future.
When monetary policy comes into play, the coordinating function of interest rates might become misleading. An increase in money supply which forces the interest rate
2 The natural rate, also called equilibrium rate, describes the interest rate which would prevail without monetary intervention. This rate would be determined by demand for and the supply of savings. If the money rate of interest coincides with the natural rate, the rate remains neutral on its effects on the prices of goods (Hayek, 1935, p. 23-24).
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below its natural level signals producers to engage in capital investments rather than on production of consumption goods. As consumer preferences as well as total resources remain unchanged, the remaining resources are directed into unwanted long-term product development where some of the capital investments cannot be completed. Ultimately, with the depletion of the subsistence fund or end of easing monetary policy these misallocated resources are liquidated, prices fall and the economy bursts.
Although the two views presented above have several similarities, they are intrinsically different (Bordo & Landon-Lane, 2013; Bordo & Wheelock, 2004). Both theories regard monetary policy as a driver of asset prices; however, while the focus of the monetarist view is on changes in liquidity, i.e. money supply, the Austrian view focuses on the effect of interest rates and credit supply which have its source in alterations of the quantity of money. Another key difference is the role asset prices play in the transmission of monetary policy to the economy as a whole. In the monetarist view, the role of asset prices has a passive character as a channel transmitting monetary policy changes into the economy. As such, asset price changes are considered as a harbinger of future inflation of the general price level. In contrast, the Austrian view attributes a more active role to asset prices being an inherent element of economic cycles. Thereby, an asset price boom, whatever its cause, can turn into a bubble if accommodative monetary policy allows credit to rise to fuel the credit-financed investment boom. Unless monetary policy hinders credit-financed investment booms, a crash which may turn in serious recession might be inevitable.
Besides the theory, there are many empirical studies that look at the relationship between monetary policy and asset price cycles. For instance, Detken and Smets (2004) identify asset price booms since the early 1970s and characterize what happens
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during the boom, just before and immediately following it. The authors look specifically at the relationship between monetary policy and prices of equity, commercial and private real estate. Monetary policy is captured by changes in short term interest rates, money and credit aggregates as well as deviations from the Taylor rule; an asset price boom is defined as a period when real asset prices are more than 10 percent above their recursively estimated trend. The analysis further distinguishes between booms that are followed by a large recession (high-cost booms) and those that are not (low-cost booms). The analysis concludes that high-cost booms seem to follow very rapid growth in the real money and real credit stocks and that high-cost booms are associated with significantly looser monetary policy conditions over the boom period. Another recent study (Bordo & Landon-Lane, 2013) focuses on the effect of monetary policy on housing, stock and commodity price dynamics. Looking at the time interval from 1920 to 2011, the study uses a panel of up to 18 OECD and determines the effect of loose monetary policy on the asset price dynamics in the housing, stock and commodity market. This analysis uses deviation of a short term interest rate from the optimal Taylor rule rate and the deviation of the money growth rate from the target growth rate as measure of monetary policy. Thereby, loose monetary policy is defined as having an interest rate below or money growth rate above the respective target rate. The empirical findings show that loose monetary policy is increasing asset prices. The results furthermore indicate that the loose monetary policy effect is strengthened during periods of fast price increases and the subsequent market correction across multiple asset classes and different specifications.
The two essays presented in the following two chapters contribute to this literature by investigating the relationship between monetary policy and asset price dynamics in two specific markets.
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The first essay presented in chapter two examines the impact of the monetary policy of the European Central Bank (ECB) on real estate price bubbles in Greece, Ireland, Portugal and Spain. The main motivation to look at these countries is that these countries stand in the epicenter of the ongoing financial crisis in Europe. These countries strongly relied on the construction sector, making them particularly vulnerable to the collapse of the real estate sector. This study attempts to determine the extent to which these countries experienced property bubbles and to examine the role of ECB’s monetary policy in the formation of these bubbles. The analysis builds on the theory on asset bubbles developed by Stiglitz (1990) and applies the direct capitalization approach through weighted average cost of capital (WACC) to identify real estate bubbles in the period from the inception of the single monetary policy in the Eurozone in 1999 to 2012. Thereby, the essay looks at two critical monetary policy variables, the loan-to-GDP ratio as a measure of bank lending activities and the 3-month Euribor as proxy for the key interest rates set by the ECB. The short-run and long-run dynamics between monetary policy variables of the ECB and the real estate bubble in the four countries are investigated by applying cointegration tests, Vector Autoregression (VAR) and Vector Error Correction (VEC) models.
The second essay presented in chapter three focuses on the link between the monetary policy of the People’s Bank of China (PBC) and global commodity price dynamics. In light of China’s emergence as world’s second largest economy and dominant player in commodity markets, the main motivation is to gain an understanding of its monetary policies on global commodity prices. Thereby, the preposition is that not only China’s economic activity as suggested by past literature but also the monetary policy of the PBC has a significant impact on global commodity prices. The analysis draws from the commodity price overshooting theory developed by Frankel (1986, 2008) and
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examines the long- and short-run dynamics between global commodity prices of the agriculture, energy, industrial metals, livestock and precious metals sector, economic activity and real interest rate of China in the period from 1998M01 to 2012M12. The time period starts at the point when China accelerated banking sector reforms and officially replaced its credit quota system by a target system and interest rates started to be increasingly determined by market forces. In order to account for the exchange rate regime change in China, the analysis further considers a dummy variable capturing the move of China from a fixed exchange rate regime to a managed floating exchange rate regime in 2005M07. To investigate the long- and short-run dynamics between the variables, this study applies Toda and Yamamoto (1995) type Granger causality tests on lag augmented VAR models and generalized impulse response function analysis.
The last chapter summarizes the key points of the two essays on monetary policy and asset price dynamics and derives a short conclusion.
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