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Monetary Policy and Asset

under Time-varying Degree of
Agency Cost

Nuwat Nookhwun

Research Paper,
Nuwat Nookhwun

Academic Year 2008

The Faculty of Economics,

Chulalongkorn University, Thailand
March 2009

Monetary Policy and Asset Price under Time-varying Degree

of Agency Cost

This paper was written as a part of “Research Paper” subject, taught
in the bachelor’s degree at the Faculty of Economics, Chulalongkorn
University, in the academic year 2008.
This paper is an individual study. Any views or findings from this
study do not reflect those of the institutions
I would like to thank Pongsak Luangaram, Ph.D. from Warwick
University and lecturer at Chulalongkorn University, for a kind
assistance as an advisor of this paper. He helped me a lot in guiding
the appropriate topic, commenting on the model, and suggesting many
interesting arguments concerning the topic. Moreover, I do admire his

Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Nuwat Nookhwun
March 2009

The on-going subprime crisis has again raised the issue
of whether central banks should use monetary policy to
prevent asset price bubble. This paper presents an adapted
version of the theoretical model used by Carlstrom and Fuerst
(2001A) to address this issue. The model is constructed
under the assumption of imperfect credit market which the
entrepreneur’s net worth can affect its ability to produce. The
net worth, in turn, is determined by asset price. The
adaptation of the model involves the assumption that the net
worth is not the only factor determining the firm’s borrowing.
It also depends on the current degree of agency cost. This
paper regards this degree of agency cost as measure of credit
boom and bust.
The results show that there is a welfare-improving role
for a monetary policy that responds actively to asset price,
productivity and agency cost shocks. This activist policy
allows the economy to respond to shocks in an efficient
manner by smoothing the fluctuations in the collateral

dedication in studying and lecturing monetary economics.

Nuwat Nookhwun

constraint. Moreover, the size of the response depends on the

effectiveness of the credit channel of the monetary policy and
the steady-state degree of agency cost.

Nuwat Nookhwun
112 Soi Areesampan 2
Paholyothin Rd., Bangkok,
Thailand 10400

Monetary Policy and Asset Price

under Time-varying Degree of Agency Cost
Nuwat Nookhwun
March 2009

1. Introduction

The on-going subprime crisis has again raised the issue

of whether central banks should use monetary policy to
prevent asset price bubbles; the issue that is still controversial
and challenging to all central bankers. However, it is
different this time. The impact of the collapse of house price
bubble occurred in the United States is so severe that many
considered it the most severe economic crisis since the Great

Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Depression in the 1930s. The bursting bubble led to a rise in
mortgage delinquency and foreclosure which contributed
many financial institutions to write down their loss from
default and an investment in mortgage-backed securities
(MBS) and collateralized debt obligations (CDO). Financial
crisis eventually occurs, and fear of recession spreads all over
the world. Apart from the role of securitization, poor
performance by credit-rating agencies and lack of regulation
in subprime mortgage market, monetary policy is to be
blamed for that.
The Federal Funds rate was held too low for a long
period with the objective to overcome the recession that was
caused by the burst of DOTCOM bubble together with the
terrorist attack both in the early 2000s. The unusually low
U.S. policy rate caused excessive liquidity and a speculation
in housing market which subsequently led to a bubble. Taylor
(2007) points out that by slashing interest rates by more than
the Taylor rule suggested, the Federal Reserve (FED)
encouraged a house price boom. Though FED has started
increasing the rate since the second quarter of 2004, such
tightening should be implemented since 2002. With a higher
Federal Funds rate, there would have been a much smaller
increase in housing starts. Moreover, Manchau (2007)
suggests that “it is time to learn that main lesson of this

Nuwat Nookhwun

crisis, which is that credit matters for monetary policy, a fact

over which many central bankers are still denial.” The closer
a real interest rate gets to zero, the greater the incentives
become for people to take on large amounts of debt. He also
interestingly mentioned that many central banks encountered
a dilemma during an onset of the crisis as a low inflation
and a rising house price bubble occurred simultaneously.
Eventually, the central bank that attempted to prick the
bubble, e.g. Riksbank, unlike FED, could escape the crisis.
Both authors above view monetary policy as a cause of
the present economic disruption and seem to support the role
of monetary policy in responding to the asset price bubble.
However, a number of prominent economists still disagree
with the proactive role. The reasons are not different from
what have been debated for a decade. They include, for
example, the difficulty in identifying bubble, ineffectiveness
of the monetary policy in dealing with it, and limited cost of
bursting bubble on the economy. In Kohn (2008), though he
believes that central banks can identify whether the asset
price rise is warranted by fundamentals, it is still difficult to
identify in a timely manner. He also argues that small-to-
modest policy actions might not be enough to contain
speculation. The only argument supporting the role of
proactive policy concerns the effect of the bursting bubble as

Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
it can be far more painful than what he has previously
imagined. Mishkin (2008) also suggests monetary policy
respond to asset price movement, whether bubble occurs or
not, if and only if it has implications for inflation and output.
Apart from those reasons made by Kohn, he believes
monetary policy actions are a very blunt instrument because
they would be likely to affect prices in general, rather than
those in a bubble. That creates a further distortion in the
economy. Besides, he supports regulatory policies and
supervisory practices to help strengthen the financial system
and reduce its vulnerability to asset price cycle. Indeed, his
view is in accordance with the present FED governor, Ben S.
Therefore, the continually debating issue of whether
monetary policy should respond to asset price and asset price
bubble is still controversial nowadays. This paper presents an
adapted version of the theoretical model used by Carlstrom
and Fuerst (2001A) to address this issue. The model is
constructed under the assumption of imperfect credit market
which allows the linkage between the movement in asset
price and output. Under imperfect credit market, the amount
of funds each entrepreneur received is restricted to its
financial position which is represented by “collateral” or “net
worth”; consequently, increase in its asset price will increase

Nuwat Nookhwun

the collateral and firm’s ability to produce respectively.

Welfare criterion will be used to judge whether monetary
policy should have a role in this imperfect world.
In the subsequent section, I will again review arguments
concerning the role of monetary policy in dealing with the
asset price bubble that are made throughout a decade. Then, I
will discuss the role of credit in the forming of the bubble
and how the policy should react which are also important
issues as the bursting bubbles that severely affect the
economy are often associated with the credit boom. This
enhances the use of the model that includes the credit
channel when studying the consequence of the asset price
movement. The theoretical model will next be discussed and
several experiments will be conducted before eventually,
optimal monetary policy be solved. The last section will
provide you a conclusion.

2. Debates over Asset-Price Bubbles and

Monetary Policy4
Debates in this and the following sections are primarily summarized
from the following literatures: Bernanke (2002), Kohn (2006, 2008),
Mishkin (2008), Posen (2006), Roubini (2006) and Trichet (2005).
Most of them have negative views in attempting to contain asset-price

Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost

Basically, as introduced by Kohn (2006, 2008) there

are two strategies having been proposed for dealing with
market bubbles. They are “conventional strategy” and “extra
action.” Conventional strategy involves responding to asset
prices, e.g. stock or house price, only insofar as they have
implications for output and inflation over the medium term.

This strategy includes “mopping up after” the bubbles have

already exploded. It is believed that if monetary policy
responds immediately to the decline in asset price, the
negative effects from a bursting bubble are likely to be small.
On the other hand, extra action attempts to damp speculative
activity by tightening monetary policy above and beyond
what the standard Taylor rule suggests. However, taking extra
action would entail some costs, creating higher
unemployment and lower inflation than would be desired.
Thus, this strategy involves trade-off worse macroeconomic
performance today for the chance of better performance in
the future. It is also known as “Proactive”, “Preemptive”, or
“Leaning against the wind” policy.

See Mishkin (2008) for an explanation of how asset prices interrupt
inflation and aggregate economic activity.

Nuwat Nookhwun

As stated in the introduction, the debates over which

strategy is the most appropriate has not yet reached a final
round. A number of arguments made by supporters of both
strategies are so convincing that challenge central bankers’
ability to choose a proper policy if next asset price bubble
occurs. I will begin here by introducing economic distortions
created by the bubbles that support the use of the proactive
In Cecchetti (2004), he states that the asset price
bubbles cause damages to entrepreneurs’ investment
decisions, households’ investment and saving decisions, and
the government’s fiscal policy decisions. For firms,
unjustifiably high equity prices make it too easy to obtain
financing. Internet companies can raise large sums of money
in equity markets in the 1990s during the onset of DOTCOM
bubble, which was to crash several years later. The funds
they used could clearly have been better invested in a more
productive sector. Concerning consumers’ behavior,
individuals feel wealthier during asset prices rise. More of
their income is spent while their saving fades away. When
the bubbles eventually burst, wealth is recomputed and
consumers are left with houses and mortgages that are too
large for their paychecks, and investment accounts that are
shadows of what they once were. Government financing

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Agency Cost
decisions are also distorted. As equity prices rise, tax
revenues tied to capital gains go up. Increased government
revenue leads to increases in expenditure and cuts in taxes.
With the bubble burst, tax revenues have fallen dramatically.
However, it is impossible to raise taxes, and the result is a
combination of expenditure cuts and increased borrowing, and
ultimately a fiscal imbalance.
Apart from those distortions, bubbles can cause financial
and real economic instability when they burst. Asset prices
can affect value of collateral and thus the provision of credit,
thereby influencing aggregate spending. In case of sharply
falling market valuations, these adverse credit-channel effects
may even be exacerbated by the deteriorating health of banks
and other financial institutions. The on-going subprime crisis
is obviously a good illustration. Therefore, because economies
often fare very poorly after bubbles burst, central bankers
may attempt to control such bubbles to avoid such severe
Though bubbles can cause damages to economic
decisions, and financial and real economic stability, there are
reasons why monetary policy should not be used in dealing

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with such bubbles. The major one among opposing views


involves the difficulty in identifying the bubbles. It is

difficult to say confidently whether the asset price rise can be
warranted by fundamentals or not since not all the
fundamental factors influencing asset price are directly
observable. Thus, any judgment by central banks that assets

are over priced is unavoidably highly uncertain. Mistakenly

identify the bubbles may result in significant costs as
mitigating a non-exist problem reduces real economic activity
and inflation below their desired level. Kohn (2008) tells us
that during the onset of the subprime crisis, staffs throughout
FED examined whether house prices were over valued and
arrived at a wide range of answers which kept them
unconfident that bubbles were already in progress. So, they
remained its conventional strategy. A variation of this
argument is how the FED can be a better judge than markets
about the existence of bubbles. If bubbles occur, market
participants should be the first one to recognize.

This paper summarized 3 opposed arguments based on Kohn (2006,
2008). See those literatures for details and development of those
arguments. 2008 speech revisited the same issue as a result of the
subprime crisis.
See Bernanke (2002) for possible indicators of fundamental value.

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Agency Cost
However, given that central banks could identify the
bubbles confidently and market participants would not
quickly arbitrage those mispricing away , timing is still an

issue. Given the lags in the monetary transmission and

uncertainty about the duration of bubbles, raising interest
rates might actually risk exacerbating instability. The
resulting contraction effects on the economy would occur just
when the adverse effects of the bubble collapse are being
realized, worsening rather than mitigating the effects of the
bubble collapse. The policy really does nothing to influence
speculative activity.
Moreover, Bernanke (2002) points out an interesting
argument concerning that after identifying bubbles, central
banks need to substitute their judgments for those of the
market. The negative consequence is that their attempt to
substitute their judgments can affect long-run stability and
efficiency of the financial system. Such attempt would only
increase the unhealthy tendency of investors to pay more
attention to rumors about policymakers’ attitudes than to the
economic fundamentals.
See reasons in Kohn (2008). Kohn also believes that events of latest
house price bubble made him little less dubious that policymakers can
reliably identify a serious bubble before it bursts, but timing still

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Nevertheless, proponents of the proactive policy might

counter-argue this identification matter. Roubini (2006)
argues that most theoretical models suggests uncertainty about
the occurrence of bubbles does not qualitatively change the
nature of optimal policy decisions that it should react to asset
prices in addition to output and inflation gap. Even if
monetary authorities cannot separate with certainty the two
components of an asset price, bubble and fundamental, the
optimal policy response implies reacting to the overall asset
price. The greater the uncertainty, the less the policy will
react to that variable. No response is, exactly, not a solution.
Actually in practice, central banks always face with
uncertainty in implementing policy. There are, for example,
data, parameter and model uncertainties. However, central
banks do not drop inflation or output from their
considerations because it is hard to estimate potential output
and expected inflation in rapidly changing economic structure.
So, there is no reason to ignore asset price bubbles as result
of an inability to identify them with confidence.
Another important reason by the critics of proactive
policy concerns the ability of monetary policy to influence
bubbles. They believe that in order to prick bubbles, the
monetary policy response would need to be large enough that
may lead to a recession and create greater damage than

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
potential harm bubbles generate. As a bubble is rising,
investors expect very high returns from the increase in asset
prices, sometimes as high as 100% per year. Therefore, a
modest increase in short-term interest rates would have a
limited impact on irrationally exuberant investors. Moreover,
central bank is truly not the only source of liquidity. In the
almost-perfect credit market, investors can depend on external
funding. As a result, aggressive tightening policy may be
needed and that makes ‘‘safe popping’’ impossible because
there is the risk of throwing the whole economy into
recession. Critics of bubble pricking often presented the
example of the 1929 stock market crash which the tightening
monetary policy rapidly led to market crash and dragged the
economy down. Therefore, “mopping up later” might be a

better policy.
Many conventional economists also refer that “monetary
policy actions are a very blunt instrument” as there are many
asset prices, and at any one time a bubble may be present in
only a fraction of assets. So, policy actions would be likely
to affect asset prices in general, rather than solely those in a
bubble. Mitigating capital misallocating in one sector would
Some economists believe that the stock market decline was more the
result of developing economic weakness (and tight money) than the
cause of the slowdown. See Bernanke (2002) for details.

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have created misallocating elsewhere. Assenmacher-Wesche

and Gerlach (2008), using a panel of 17 OECD countries,
confirms that monetary policy is really empirically too blunt
an instrument to be used to target asset prices since the
authors found that the effects on real property prices are too
small, given the responses of real GDP, and they are too
slow, given the response of real equity price. Thus, in
attempting to prick house price bubble, the well-functioning
stock market may crash in advance, and much of GDP must
be traded-off.
In addition, Posen (2006) cites in his paper that some
researchers failed to find any robust connection between
liquidity and growth in asset price. By studying asset price
boom in OECD countries, only one-third of monetary ease
leads to bubbles. The other illustration is from Japan’s
experience. As early as 1987, BOJ started expressing doubts
about bubble and even started raising interest rate. However,
the great bubble went on building until January 1990.
Supporters of preemptive policy might oppose by
mentioning that a monetary policy that reacts to asset bubbles
does not need to lead to severe economic contraction.
Roubini (2006) states that in any asset bubbles, there are
elements of a credit boom, reaching for yield, increasing
leverage and increasing and excessive risk taking by

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
investors. All these economic and investment decisions do
depend on interest rates and the stance of the monetary
policy. Therefore, the interest rates can affect both credit
conditions and the economic decisions that, in turn, affect
asset prices. The recent experiences of housing bubble in
early 2000s in the United Kingdom, Australia and New
Zealand also suggest that it is possible to react to bubbles
with a moderate and gradual monetary policy tightening
without causing a financial and economic crash. The soft
landing of those economy was so successful.
Indeed, the examples cited by the critics of preemptive
policy, such as Bernanke, are all cases in which the asset
bubble policy management was terrible. In Japan in the
1980s, the Bank of Japan waited too long to deal with the
housing and equity bubbles and too long to ease to deal with
aftermaths. The case of Japan is similar to the US case of
1929 which is a classic example that the FED did not
respond immediately after one official signaled occurrence of
bubbles. Also, in the 1990s technology bubble, the monetary
easing was probably excessive and could reverse earlier and
faster. A less ‘irrationally exuberant’ Greenspan, an earlier
Fed policy of tightening and the use of other instruments to
control leverage could have had an effect on the bubble.
Moreover, most recently, as Taylor (2007) finds out,

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subprime crisis was also partially caused by too low interest

rate for a long period. The reverse of the policy rate was not
quick and high enough. At that time, though Greenspan
alarmed seriously about housing bubble since 2005, he also
thought that central banks could not successfully target the
Apart from identification and policy effectiveness issues,
the other opposing argument by conventional supporters is
that the effect caused by bursting bubbles is limited. Risk-
averse policymakers might not regard the expected return
from extra action insurance as worth its premium. Posen
(2006) mentions that bubbles can do harm to the economy
only when there is financial fragility, especially in the case
when collateral interact with the provision of credit through a
banking system. One can imagine circumstances under which
an asset price bust could lead to a protracted recession. The
size of such negative effects in practice importantly depends
upon structure and condition of the financial system at the
time of the asset price shock. Thus, well-capitalized and
properly supervised banking systems tend to keep the
economy resilient to shocks. It can be inferred, however, that
bubbles’ damage to the economy is really not a monetary
issue, but an issue of financial structure and supervision.

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Monetary Policy and Asset Price under Time-varying Degree of
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In the high-tech boom, for example, the U.S. financial
system remained healthy after the collapse. That obviously
mitigated the real effect caused by bubble burst. In contrast,
the Great Depression in the United States, like Japan’s Great
Recession, did not arise immediately following the asset price
bust because severe banking system distress was combined
with damagingly tight monetary policy over years that output
declined. Kohn (2006) mentions accordingly that the
nonlinear risks associated with a collapsing bubble may
depend on the initial health of the financial system.
Prudential supervision in advance and prompt action to clean
up any problems afterwards would be better way to deal with
Moreover, market corrections can also have severely
adverse consequences if they lead to deflation, as illustrated
by 1929 stock market crash and the experience of Japan. But
it does not follow that conventional monetary policy cannot
adequately deal with the threat of deflation by immediately
mopping up after the bubble collapse. Extra action may
actually exacerbate the problem under the circumstances that
inflation has already started out at a low level.
However, it is confident to say that the costs of recent
subprime crisis have turned out to be gigantic which some

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considered it the worst financial crisis of the century. The


housing bubbles, together with the integration of worldwide

financial system and the sophistication of financial
innovation, led to the worst financial and economic crisis.
Banks and financial institutions have exposed to such heavy
losses that mopping-up have turned out to be harder. This
severe fallout may indicate a larger potential gain if
attempting to prick the bubbles in the first place.
Policymakers will be much more aware of the threat of the
bubbles in this unceasingly developing world, especially when
there is signal of financial instability.
Actually, even authors that argue against monetary
policy targeting of asset prices has already acknowledged the
analytical channels that link asset bubbles to real and
financial variables including wealth effects and credit
constraint effects. A number of studies suggest that credit
booms and busts and asset price booms and busts can have
severe financial and economic consequences. Many of the

crises are preceded by asset bubbles and credit boom that

eventually became unsustainable.

See Kohn (2008). He totally changed his view from previous 2006
Cited from Roubini (2006)

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Monetary Policy and Asset Price under Time-varying Degree of
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Next, I would like to turn to interesting proactive
argument which concerns moral hazard problem. It is correct
to say that monetary policy needs to provide lender-of-last-
resort support to financial markets in the period of liquidity
seizure, following bursting bubbles. But, like any other form
of insurance, such lender-of-last resort liquidity support, while
allowing asset bubbles to grow without doing anything, may
lead to moral hazard distortions. As market participants
believe that central banks would bail them out when the
collapse occurs, they are encouraged to carelessly take risks.
So, in practice, it should have been accompanied by a
willingness to control the rise of bubbles when they do occur.
Critics would argue that an increase in interest rates that
results in less availability of credit would itself increase the
adverse selection problem. To explain clearly, individuals and
firms with the riskiest investment projects are those who are
willing to pay the highest interest rates. If market interest
rates are driven up sufficiently, participants with good credit
risks are less likely to want to borrow. Only bad-credit or
risky borrowers are left in the market. Therefore, there is no
reason to think that in increase in interest rates would punish
the more spendthrift banks and borrowers for their supposed
lack of discipline during the bubble’s expansion.

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Kohn (2006) also debated that this moral hazard

argument is a misreading of history. U.S. monetary policy
has always been consistent with its mandate, which is to
stabilize employment and inflation. The Great Moderation is

the most convincing evidence. In addition, critics can argue

that extra action may pose a more significant risk of moral
hazard. If a central bank takes extra action but speculative
activity continues unabated or even intensifies, how would
the strategy be? Do policymakers raise rates even further?
What are the consequences for the economy? Importantly,
one may perceive asset price targeting as another goal of
central banks.
Beyond those debates, there is an idea to find other
proper types of policy responses. Many economists believe
that the impact of bubbles has far more to do with financial
supervision and regulation. Bernanke (2002) has for a long
time believed that the FED should the right tool for the right
job. It should focus its monetary policy instruments on
achieving its macroeconomic goals while using its regulatory,

However, some blame “The Great Moderation” as the cause of the
latest crisis as it may have led many private agents to become less
prudent and to underestimate risks associated with their actions.
Monetary policy is subsequently blamed for contributing to the Great
Moderation. See Kohn (2008).

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supervisory, lender-of-last-resort approaches to help ensure
financial stability. Specifically, the FED should ensure that
financial institutions and markets are well prepared for the
impacts of a large shock to asset prices. Banks should be
well capitalized and well diversified. The central banks can
also contribute to reducing the probability of boom and bust
cycles occurring in the first place, by supporting more-
transparent accounting and disclosure practices and working
to improve the competence of investors. During the crisis, the
central banks should provide ample liquidity until the
immediate crisis has passed. However, Cecchetti (2004) still
claims that until the efficacy of alternatives is proven, interest
rates are the only tool and the right response to emerging
price bubbles is to raise interest rates.
Considering again the monetary policy, though those
debates above suggest that in practice there are both
agreements and disagreements in conducting preemptive
monetary policy, however if focusing on the theoretical
literatures, many analytical models seem to support the role
of such policy ; some particularly support a non-linear one.

Bordo and Jeanne (2002A, B) interestingly concludes that the

See Roubini (2006) for other theoretical literatures supporting
preemptive policy. See also Posen (2006) for alternative views.

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optimal policy cannot be summarized by a simple policy rule

of the type so-called the Taylor rule. It depends on the
economic conditions in a complex, non-linear way. The level
of optimism is the factor that should be considered in making
policy decisions and there is a role for preemptive policy at
the intermediate level of optimism. Moreover, Gruen, Plumb,
and Stone (2005) shows that the optimal monetary policy
recommendations of the activist depend on the stochastic
properties of the bubble. The case for leaning against the
bubble bursting with monetary is stronger the lower the
probability of the bubble bursting of its own; the larger the
losses associated with bubbles, and the higher the impact of
monetary policy on the bubble process. Thus, this last
literature has given various conditions to decide whether to
implement a proactive policy. Note that all conditions are
almost related to the controversial debates above.

3. The Coincidence of Asset Price Bubbles and

Credit Boom

The debates above contribute to one important finding

that bubbles can do harm to the economy if there is financial
fragility. In this section, I further investigate this finding.

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Mishkin (2008) points out that some asset price bubbles can
have more significant economic effects, and thus raise
additional concerns for economic policymakers, by
contributing to financial instability. He interestingly reveals
the following typical chain of events.
“…Because of either exuberant expectations about
economic prospects or structural changes in financial markets,
a credit boom begins, increasing the demand for some assets
and thereby raising prices. The rise in asset values, in turn,
encourages further lending against these assets, increasing
demand, and hence their prices, even more. This feedback
loop can generate bubble, and the bubble can cause credit
standards to ease as lenders become less concerned about the
ability of the borrowers to repay loans and instead rely on
further appreciation of the asset to shield themselves from
losses. At some point, however, the bubble bursts. The
collapse in asset prices then leads to a reversal of the
feedback loop in which loans go sour, lenders cut back on
credit supply, the demand for the assets declines further, and
the prices drop even more. The resulting loan losses and
declines in asset prices erode the balance sheets at financial
institutions, further diminishing credit and investment across a
broad range of assets. The decline in lending depresses
business and household spending, which weakens economic

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activity. In the extreme, it can endanger the operation of the

financial system as a whole. …”
The above quotation illustrates the feedback loop which
helps generate the coincidence of credit boom and asset
price appreciation that triggers financial instability and
fragility afterwards. Asset price bubbles and credit boom

could fulfill each other in their occurrence. Credit has role in

the forming of the bubbles through the flow of capital into
assets while bubbles, in turn, contribute to the credit boom
through collateral-constraint effect. Unfortunately, the
coincidence of both places a significant threat to the economy
when there are reversals.
The historical examples have also highlighted the role
of financial instability in determining the consequence of
asset price bust as well. The stock market boom of the

1920s was subject to easy credit and rising speculation.

There was speculative use of credit and when the market
collapsed, the banking system got into trouble. Turning to
Japan’s asset prices boom, there were an evidence that the

Trichet (2005), interestingly, views that it is possible that asset
price bubbles moderate the effects of financial market frictions, like
credit constraint, and improve the allocation of investment. But it
should not be at the expense of a stable financial system.
See Mishkin (2008) for full explanation of each crisis.

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ratio of bank loans to gross domestic product surged and also
a financial deregulation which increases banks’ risk-taking
behavior. The subsequent decade after the bubble burst have
been termed the lost decade. Japan’s experience suggests the
importance of regulatory policies that prevent feedback loops
between asset price and credit provision. During the boom,
Japanese regulation that allowed banks to count as capital
unrealized gains from equities might have contributed to
banks’ appetite for equities during the run-up and to financial
instability when the market collapsed. The on-going
hamburger crisis, named after its origin, really confirms the
role of credit expansion during asset price bubbles. The
securitization process made ample liquidity available in many
markets especially the bubbled subprime mortgage market.
The lenders began to ease standards as further appreciation in
house prices was expected. The process also linked the
unjustified mortgage market to worldwide financial market
through securitized product, for example the MBS and the
CDO, while investors of those products failed to investigate
risks. Once the subprime market collapsed, the financial
market was dragged down and eventually real economy falls
into recession.
In the statistical view, Trichet (2005) cites two
academic literatures on early warning signals which conclude

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an adverse role by both factors. One literature shows that

when both credit-to-income ratio and real aggregate asset
prices simultaneously deviate from their trends by 4
percentage points and 40% respectively would have predicted
55% of financial crisis three years in advance. In another

paper, ECB staff found that broad money and credit

developments are among the few early indicators of high-cost
asset price boom periods. Bernanke (2002) also supports this
statistics by saying that during recent decades, unsustainable
increases in asset prices have been associated on occasions
with botched financial liberalization in both emerging and
industrialized countries. The liberalization was not matched
by increase in regulatory supervision and that resulted in a
rapid flow of credit into assets.
Given theoretical and empirical evidences above, the
fulfilling process of and the threat posed by such coincidence
are what central bankers should take into account. Therefore,
approach to regulation should favor policies that will help
prevent future feedback loops between asset price bubbles
and credit supply. Mishkin (2008) suggests interesting

Mishkin (2008) infers that credit condition can help identify
bubbles. When asset prices are rising rapidly at the same time that
credit is booming there may be greater likelihood that they are

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
examples. The rise in asset values that accompanied with a
boom must not result in higher capital buffers at financial
institutions, supporting further lending. Another one is that
capital requirements may be adjusted over the business
cycles. Moreover, regulation and prudential supervision must
address concerns about risk-taking behavior which are one of
major causes of the many crises.
Concerning monetary policy instruments, Disyatat
(2005) proposes targeting both, which he refers as the cause
of financial imbalances, explicitly in the central banks’ loss
function. He cited the main concern of the proactive view is
that the economy could be left to grow at an unsustainable
pace if monetary authorities do not respond to developing
financial imbalances, and finally could have adverse
consequences for the goals of policy when they implode.
Thus, monetary policy should help lower the probability of a
disruption occurring in the first place. As a result, there must
be an explicit consideration for financial imbalances in the
loss function of the central bank, in addition to that of output
and inflation. The measure of financial imbalances adopted
by the authorities is assumed to be weighted average of asset
prices and household debt, the latter reflecting primarily bank
credit extension. Therefore, this literature moves another step

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Nuwat Nookhwun

forward in letting central banks target both the bubbles and

the credit boom.
Before moving further to the theoretical model, I would
like to discuss the links between monetary policy, and credit
expansion and asset price. The model used in this paper
includes such links. Indeed, monetary policy can basically
affect, based on theory, both asset price and credit boom via
monetary transmission mechanism and can be a cause of

both asset price bubble and credit boom. The link to asset
price can easily be described by considering interest rate as
the opportunity cost of holding assets, thus lowering the
policy rate results in higher demand in asset market, and thus
asset prices.
In considering the effect to credit provision, asymmetric
information problem in the credit market is addressed. There
are two basic channels which the policy operates through.
The first one is the balance sheet channel which operates as
follow. Expansionary policy, which causes a rise in asset
prices, raises the net worth of firms and so leads to more
loans available because of the decrease in adverse selection
and moral hazards problems. The other one is the cash flow
channel. It tells us that expansionary policy causes an

See Mishkin (2007) for the transmission mechanism of monetary

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
improvement in firms’ balance sheets because it raises cash
flow from interest payment. The rise in cash flow increases
the liquidity of the firm and thus makes it easier for lenders
to know whether the firm will be able to pay its bill. The
result is that adverse selection and moral hazard problems
become less severe, leading to an increase in lending.

4. The Theoretical Model

Let me remind you first that I attempt to find out

whether monetary policy should respond to asset price.
However, though the previous two sections mostly discuss
about the asset-price bubbles, this theoretical model is
regardless that asset price movement is a bubble or can be
warranted by fundamentals because it will be proven that
both types of movement can result in an inefficient
adjustment of the economy. The model here, as mentioned
previously, is a revised version of the model implemented by
Carlstrom and Fuerst (2001A). It is built upon Kiyotaki and
Moore’s model and describes the world under imperfect

Kiyotaki and Moore wrote the related paper in 1997. It is named
“Credit Cycles,” published in Journal of Political Economy.

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Nuwat Nookhwun

credit markets which firm’s borrowing is subject to its

financial position which can be represented by its collateral
or net worth. So, that collateral constraint will have an effect
on the firm’s ability to borrow and thus its production.
Therefore, the model allows the effect from the collateral
shock that is resulted from the movement in asset price to
have an influence on the economy. That really captures the
real world’s situation which asset price shock usually
influents the economy through credit channel. Eventually,
welfare criterion will be used to judge the optimal policy.
The adaptation of the model involves the assumption
that the net worth is not the only factor determining the
firm’s borrowing. Indeed, the firm can borrow higher or
lower than its collateral depending on degree of agency cost.
Lower degree of agency cost implies that lenders are more
confident that their loans will be repaid. Thus, the collateral
constraint is more relaxed and that results in more funds
available to the firm. I will explain this thoroughly later. But
from the previous section, we may regard this degree of
agency cost as measure of credit boom and bust. In the
period of credit boom, the agency cost is low and that
enables the firm to borrow in a considerable amount. We
may also study additionally what role monetary policy should

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
have on this variable. Moreover, the other important
adaptation of the model is that it can capture the effects
monetary policy has on both asset price and the degree of
agency cost (or credit condition). The previous section has
already described in details their transmission mechanisms.
There will be an implication from the credit channel of
monetary policy when we reach conclusions.
Now, I will start explaining the structure of the model.
This theoretical model consists of 2 representative economic
agents: households and entrepreneurs. I will discuss their
economic decisions thoroughly.

Households’ Behavior
The households are the agents that distribute their labor
supply to entrepreneur’s production. The income received
from working is mainly used for their consumption and
saving. They live infinitely and their period-by-period utility
function is given by
U ( C t , Lt ) = C t −

1 (1)
The utility function is built for simplicity when
analyzing their maximization behavior. The future utility is
discounted at rate β. Ct denotes the households’ consumption

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Nuwat Nookhwun

in term of consumption goods while L denotes labor supply.


Their utility function implies that the households’ utility is

increasing with consumption and decreasing with labor
supply. Increase in labor causes the households less leisure
and thus reduce their utility, but they still have to work in
order to receive income in the form of real wage w to pay t

their consumption. So, in each period, they primarily have to

decide how much to consume and to work.
In addition, after consumption, households have to make
their saving decision. There are 2 means of saving. The first
mean is in the form of bond B which pays gross interest rate

of Rt next period. The other one is in the form of acquiring

shares to a real asset that pays out dividends of Dt

consumption goods at the end of time-t. The exogenous

dividend process is given by
Dt +1 = (1 − ρ D ) D + ρ D Dt + ε tD+1 (2)
The process is an AR1, which next period’s dividend is
a weighted average of today’s dividend and the long-run
average of dividends ( D ) plus a random i.i.d. shock ( εt +1 ).

Such shock is so-called dividend shock or asset price shock

which is the important source of the movement in asset price
that I will find out its appropriate monetary policy response
later. ρD can be considered as a lagged effect the present
dividend has on the future dividend. This coefficient must be

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
less than one so that the dividend converges to its long-run
The asset trades at share price qt at the beginning of
the period. The asset price depends only on such dividend
process. It is increasing with the current and future dividend
levels, as theory suggests. Its price determination equation
will be found out later. Importantly, I assume that shares
must be purchased with cash accumulated in advance so that
the households have to face the cash-in-advance constraint.
Pt f t ( qt − Dt ) ≤ M t − Bt (3)
ft is the amount of asset purchase while M is the t

money that is held in advance from the previous period to

buy asset. From the constraint above, assume further that the
dividend is available within the period to acquire asset. The
explanation of the above equation is that the cash or money
held in advance, after purchasing bond, will be used to buy
asset. This constraint generates the effect the monetary policy
has on asset price as the households have to make a decision
on the types of saving which consists of asset and bond, and
the return on the latter is directly related to monetary policy.
We will also learn more about it later.
The other constraint facing households is the
intertemporal budget constraint which is given by

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Nuwat Nookhwun
M t +1 ≤ M t − Pt ct + Pt wt Lt + Bt ( Rt − 1) + Pt qt f t −1 − Pt f t ( qt − Dt )

Pt is the price of the consumption goods. The
intertemporal budget constraint explains that revenue of the
households is generated from the money held in advance
from the previous period, labor income, bond revenue and the
asset acquired in the previous period. Note that the value of
the asset is determined by the present real price. Within the
period, the revenue of the households is used for
consumption, and saving in form of bond purchase and
acquiring asset. The money left is held in advance to the next
period to purchase asset.
To conclude, the households maximize their lifetime
utility subject to cash-in-advance and intertemporal budget
constraint. Thus, their optimization problem is such that,

 1+

∞ Ct − + λ t ( M t − Bt − Pt f t ( qt − Dt )
 t 
t 1  (5)
L = ∑ β 1+
t= 0  τ 
 
 + µ t ( M t − Ptct + Pt wt Lt + Bt ( Rt − 1) + Pt qt ft− 1 − Pt ft ( qt − Dt ) − M t+ 1 ) 

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
µt and λt both are lagrangian multiplier for each
constraint. To maximize their utility, they choose their
consumption, labor supply, bond and asset purchase, and
money held in advance to the next period.
The results of the first-order condition are shown below.
Ct : β t (1 − µt Pt ) = 0

µt Pt =1 (6)
 1

Lt βt  
− Lt + µt Pt wt  = 0

 


Lτt = µt Pt wt
Bt : β t ( − λ t + µ t ( Rt − 1) ) = 0

λt + µt = µt Rt (8)
: β [ − λt Pt ( qt − Dt ) − µt Pt ( qt − Dt ) ] + β µ t +1 Pt +1 qt +1 = 0
t t +1

β t ( λt + µt ) Pt ( qt − Dt ) = β t +1 µt +1 Pt +1 qt +1 (9)
M t +1 : β t ( − µ t ) + β t +1 ( λt +1 + µ t +1 ) = 0

β t ( µ t ) = β t +1 ( λt +1 + µ t +1 ) (10)
Substitute (6) in (7) yields

L = wt

Lt = wtτ (11)
Substitute (6) and (8) in (9) yields
Rt ( qt − Dt ) = βqt +1
q t Rt = Dt Rt + E t βq t +1 (12)
Substitute (6) and (8) in (10) yields
1 βRt +1
Pt Pt +1
βPt Rt +1
Pt +1
=1 (13)

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Nuwat Nookhwun

From the outcomes of the households’ maximization

decision above, equation 11 shows that labor supply responds
positively to the real wage. Increase in the real wage
encourages the households to supply more labor as it enables
them to generate more income for consumption.
Determination of the asset price is shown in equation 12. It
is the sum of the present dividend and the present value of
the expected asset price in the next period. Importantly, this
equation implies the link between the asset price and
monetary policy which suggests that movement in the interest
rate has a direct effect on real asset price. Because the
households have to hold money in advance to purchase asset,
the interest rate reflects the opportunity cost of such cash as
the cash can be used to purchase bond instead. Higher
interest rate contributes to higher opportunity cost and thus
lowers demand for asset and the asset price. This provides a
transmission channel in which monetary policy can have an
influence on asset price and eventually affect level of activity
when discussing entrepreneurs’ behavior. For equation 13, it
suggests that the Fisher equation is “off” a period.

Entrepreneurs’ Behavior

Fisher equation explains that nominal interest rate must rise with
the expected inflation.

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Turning to the entrepreneurs’ behavior, they too are
infinitely lived and have linear preferences over consumption.
They hire labor supplied by households to operate a constant
return to scale production to produce consumption goods.
Their production function is given by
y t = At H t (14)
where yt is consumption goods produced, At is the
current level of productivity and Ht is the number of workers
employed at a real wage w . Like dividends, the productivity

level is an exogenous AR1 random process given by

At +1 = (1 − ρ A ) A + ρ A At + ε tA+1 (15)
εtA+1 represents productivity shock, which is also of
interest in this study.
In deciding how many workers to employ, the
entrepreneur is constrained by a borrowing limit, and in
particular, it must be able to cover the entire wage bill with
its loan. Carlstrom and Fuerst (2001A,B) consider “hold-up
problem” as a reason why the firm is constrained. The
problem supposes that the hired workers first supply their
labor input, but that output is subsequently produced if and
only if the entrepreneur provides his unique human capital to
the process. Therefore, the entrepreneur could force workers
to accept lower wages ex post, for otherwise nothing will be
produced. This problem can be entirely avoided if there is an

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Nuwat Nookhwun

existing stock of collateral that the workers could simply

seize in such a case. Hence, to avoid this hold-up problem,
workers are willing to work if and only if the wage bill is
entirely covered by existing collateral. Assume further that
there exist financial institutions that provide within-period
financing to the entrepreneur, and that this financing is used
by the firm to pay their workers. The financial intermediary
will concern about the hold-up problem, and thus limits its
lending to the firm’s net worth.
The other clarification of such constraint involves the
assumption of imperfect credit markets. Only the entrepreneur
knows the details of its proposed project. If outside investors
are to provide financing to the entrepreneur, they have no
way of knowing for sure what the firm will do with their
funds. Furthermore, investors may have limited ability to
punish the firm after the fact that it run off with their money,
or use the funds on a misguided production activity. In this
scenario, external investors will likely provide financing only
if they are sure they can recoup their investment if things
turn sour. That is to limit the size of their financing to firm’s
financial position which is the collateral that can be seized
after the fact.
From both reasons above, firm’s borrowing which is
used to finance the wage bill will primarily be constrained by

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
its collateral or net worth. We will denote this collateral as n t

(net worth). The entrepreneur’s loan constraint is thus

wt H t ≤ µt nt (16)
The constraint is partially in accordance with Carlstrom
and Fuerst (2001A,B). However, the modification of the
constraint appears that the entrepreneur can borrow higher or
lower than its collateral. The degree of agency cost reflects
the ratio which it can borrow with respect to its net worth.
We denote it as µ but note that µ is the reversed value of
t t

such degree. Higher µ or lower degree of agency cost implies


higher firm’s reliability that it will use its borrowing

efficiently and repay the debt, and thus higher amount of
funds from financial intermediary or external investors. In
contrast, lower µt or higher degree of agency cost reflects
higher counterparty risk or default risk which reduces
financial institutions or outside investors’ incentive to lend.
Financial crisis, for example, may result in very very high
degree of agency cost. As already mentioned, this variable
can imply credit condition of the economy. A continually
high value of µt (significantly more than one which enables
the firm to borrow more than its collateral) may represent a
period of credit boom. Meanwhile, the lower the value of µ , t

the more difficult the financial institutions provide loans, and

that contributes to the credit bust.

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Nuwat Nookhwun

For example, kohn (2008) suggests that after 2003,

borrowing constraints were being eased by new financial
developments, such as the growth of subprime lending and
other nontraditional mortgages, fueled by investor demands
for higher yields on complex structured products. That would
result in higher µ . t

The process of the degree of agency cost is given by

µt +1 = (1 − ρ µ ) µ ss + ρ µ µt − α ( Rt +1 − R ) + ε tµ+1

Degree of agency cost is also an exogenous AR1
random process. However, it is also determined by the gross
interest rate relative to its threshold. The interest rate is
positively affected to the degree of agency cost. As described
earlier in the previous section, this relationship represents the
credit channel of monetary policy which lower interest rate
results in the extension of loan by lowering agency cost. α
shows the effectiveness of such channel. The economies, that
have a close link between monetary policy and credit stance,
tend to have high α . That is, change in monetary policy
significantly affects credit provision. From the above
equation, too low interest rate for a long period of time can
result in continually high µ which contributes to a long period

of credit boom. Lastly, the agency cost shock, εt +1 , may be


resulted from financial deregulation, financial crisis, financial

- 42 -
Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
panic, changes in the expected economic outlook and many
more. Financial deregulation poses negative agency cost
shock and increases the value of µt .

I will assume that the loan constraint binds so that labor

demand is given by
µ n 
H t =  t t  (18)
 wt 

Decrease in the degree of agency cost and increase in

the net worth enable the entrepreneur to hire more labor as
the amount which it can borrow rises. Meanwhile, wage
increase lowers the number of workers hired because the
entrepreneur has to pay its wage bill with its constrained
Note that entrepreneur’s sole source of net worth is
previously acquired ownership of asset. Therefore, time-t net
worth is given by
nt = et −1 qt (19)
where et is asset purchased by the entrepreneur. So, the
loan constraint now is given by
wt H t ≤ µt et −1 qt (20)
Importantly, the assumption that the loan constraint is
binding implies that the firm’s marginal profits per worker
employed is positive ( At − wt > 0) . The entrepreneur would like
to hire more workers because of its positive marginal profits

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Nuwat Nookhwun

earned from hiring additional labor, but it cannot because the

collateral constraint limits its ability to do so. However, these
profits also motivate the entrepreneur to acquire more net
worth which enables it to employ more workers. Therefore, it
is a need to limit this accumulation tendency so that
collateral constraint remains relevant. The entrepreneur’s
budget constraint is given by
C te + et qt = et −1 qt + et Dt + H t ( At − wt ) (21)
The RHS of the equation show that the revenue of the
entrepreneur can be acquired from its profits from production,
the selling of the asset previously acquired, and the dividend
gathered from the asset purchased in that period. The
entrepreneur’s revenue is used for 2 transactions. The first
part is for consumption, C t , and the other for purchasing asset

which unlike the households, does not require any cash in

Using the binding loan constraint, we can rewrite this
constraint as
µt et −1 q t
C te + et q t = et −1 qt + et Dt + ( At − wt )
µe q A
C te + et ( qt − Dt ) = (1 − µt ) et −1 qt + t t −1 t t

Now, to prevent accumulation tendency from happening,
I will assume that the entrepreneur consumes its dividends
and fraction of its profits each period:

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
 µe q A 
C te = et Dt + (1 − γ ) (1 − µt ) et −1 qt + t t −1 t t 
wt (23)
 

So that entrepreneur asset holdings evolve as

 µe A 
et = γ (1 − µt ) et −1 + t t −1 t 
wt  (24)

where γ represents share of firm’s profit that is used to

purchase asset.

After explaining the behavior of both economic agents,
market equilibrium is next to considered. There are two
markets in this theoretical model, the market for assets and
the labor market. The respective market-clearing conditions
are et + f t = 1 20 and Lt = H t . The equilibrium asset price is
given by q R t t = Dt Rt + E t βq t +1 . As for labor market, equating
labor supply to labor demand and solving for the equilibrium
real wage and employment level yields
τ µ t nt
wt =
wt = ( µ t nt ) 1+τ

Lt = ( µ t nt ) 1+τ

The equilibrium real wage and employment level is

increasing with net worth and decreasing with the degree of
agency cost as net worth increase and agency cost decrease
The supply of asset is normalized to unity.

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Nuwat Nookhwun

make more loans available to the entrepreneur. So, it is able

to hire more workers. Subsequently, as labor demand
increases, the equilibrium wage rises as a result. Moreover, in
this model, the implied path for the inflation rate comes from
βPt Rt +1
Et =1
Pt +1

We can use the above equations to solve for the steady-
state of the model. Let π denote the steady-state inflation
Pt +1
rate where 1 + π = Pt . Then we have:
βPt Rt +1
(27) Et
Pt +1

1 +π

(28) qt Rt = Dt Rt + Et βqt +1

R −β
 µe A 
(29) et = γ (1 − µt ) et −1 + t t −1 t 
wt 

γ µA
1 −γ + µ γ

(30) and wt = ( µ t nt ) 1+τ

nt = et −1 qt

 γµ A 
1 − γ + µ γ
e= 

(31) Lt = wtτ
 
 
τ  
 γµA  A
L =  = 
1 −γ +µγ  1 
 −1 
1 + γ 

 µ 

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
From equation (27) derived from the implied path for
inflation, the steady-state gross interest rate is increasing with
the steady-state inflation rate. This is in accordance with the
well-known Fisher equation that describes the relationship of
nominal interest rate and inflation. Equation (28) suggests
that the steady-state asset price is determined by the steady-
state gross interest rate and its steady-state dividend. Higher
dividend yields an increase in the steady-state asset price,
while higher interest rate lowers it as stated earlier that such
rate reflects opportunity cost of asset purchase. Therefore,
monetary policy does affect the share price at the steady
state. However, as the steady-state asset purchase is
negatively related with the steady-state share price as
introduced by equation (30), monetary policy will have no
effect on steady-state net worth. Note that net worth is
equivalent to the multiplication of asset purchase and its
price. As a result, it is also superneutral with respect to
steady-state employment and output.
The steady-state employment is determined by the
steady-state level of productivity and degree of agency cost.
Equation (31) tells us that the more the long-run average
productivity level, the more is the steady-state employment.
Concerning the degree of agency cost, lower steady-state
agency cost causes more steady-state employment because of

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Nuwat Nookhwun

more loans available to the entrepreneur to employ workers.

Let me remind you again that µ is the reversed value of the

degree of agency cost. High µ means low agency cost. It can


be inferred that economies that have lower agency cost, for

example developed countries, tend to have more steady-state
employment than less developed one.
Nevertheless, for any given economies, the imperfect
credit markets make the steady-state level of employment
“too low”. If there were no collateral constraint, then real
wage would be given by w = A, and employment by Lt = Atτ .

But these levels are not achievable because of such

constraint. Because γ −1 > 0 , > 0 for any given values of µ .

So, the steady-state employment is kept lower than At .


However, the most important finding from the employment is

that there is no unique optimal long run nominal rate of

Log-linearizing the model

Because monetary policy has no effect on steady-states,
it is convenient to express the equilibrium in terms of log-
deviations and study the dynamic of the economy in the
short-run. Note that the ~ represents percent deviation from
the steady state.

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
(32) Lt = ( µ t nt ) 1+τ

~ τ ~ τ ~
Lt = µt + nt
1 +τ 1 +τ

(33) nt = et −1 qt
~ =e
n ~ +q ~
t t −1 t

 µe A 
(34) et = γ (1 − µt ) et −1 + t t −1 t 
wt 

µ t At 
et = γet −1 (1 − µ t ) +
 1

 ( µ n
t t ) 1+τ

~ τ ~ 1
et ≈ ~
et −1 + µ~ +A − ~
1 +τ 1 +τ
t t t

Substitute (33) in (32) and (34) yields

τ ~ τ ~
Lt = µt + ( et −1 + q~ )
1 +τ 1 +τ
τ ~ ~
(36) ~ ~
et = et −1 + µt + At −
1 ~
( et −1 + q~t ) = τ e~t −1 + τ µ~t + A~t − 1 q~t
1 +τ 1 +τ 1 +τ 1 +τ 1 +τ

(37) q t Rt = Dt Rt + E t βq t +1

~ +R~ R −β ~ β~
q t t = Dt + Et q t +1
 R  R

(38) µt +1 = (1 − ρ µ ) µ ss + ρ µ µt − α ( Rt +1 − R ) + ε tµ+1

~ =ρ µ
~ αR ~ ~ µ
µ µ t −1 − R + εt
µ t

In summary, the economy model consists of equations

(35)-(38). There is two predetermined variable, e and
21 22

1, and four exogenous shocks: , Dt , Rt and εtµ .

µ At

Equation (35) shows that change in employment is resulted

from change in degree of agency cost, asset acquired in the

The value of is approximated by implementing the mathematical

rule: log ( ±1 + x ) ≈ log ( x )

The calculation of (37) and (38) involves total differentiation

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Nuwat Nookhwun

previous period, and asset price. Increase in those variables

all enhances firm’s borrowing. From equation (36), change in
asset purchase is determined by change in asset acquired in
the previous period, degree of agency cost, level of
productivity, and asset price. Positive changes in the first
three variables contribute to an increase in the present asset
purchase because they all raise firm’s profits which enables
the firm to acquire more asset. Increase in asset purchase in
the previous period and decrease agency cost raise the profits
by increasing firm’s ability to borrow and labor hired. On the
other hand, change in asset price poses adverse effect as its
positive change, though increases firm’s net worth and labor
demand, but also raises equilibrium wage subsequently. The
increase in wage, in turn, lowers firm’s employment and
Equation (37) explains movement in asset price, which
is negatively affected by change in gross interest rate but
positively related with change in the present dividend and
expected change in next period’s asset price. The explanation
is not different from what explains for the steady-state asset
price. Lastly, the change in the degree of agency cost is
determined by change in that degree in the previous period,
the gross interest rate, and its random shock. Expansionary
monetary policy (by lowering policy interest rate) results in

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
lower degree of agency cost (or higher µ ). The important

finding is that the effect of the same percentage change in

the monetary policy instrument rate differs across economies.
It depends on µ , the steady-state agency cost and α , the
measure of the linkage between monetary policy and credit
condition and the effectiveness of the credit channel of
monetary policy. The economies with high degree of agency
cost and/or an effective credit channel of the monetary policy
tend to have higher effect.
Next, before turning to the question of monetary policy,
it is useful to sharpen one’s economic intuition about the
model by considering several experiments. The experiments
are also useful in understanding the dynamics of the economy
and optimal monetary policy decision.

5. Shock Experiments

Experiment 1: Shock to Productivity ( A ) In order to


investigate such shock, assume there is no change in other

exogenous variables. Then we have
~ τ ~
Lt = et −1
1 +τ
~ τ ~ ~
et = et −1 + At
1 +τ

By combining, we obtain

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Nuwat Nookhwun
Lt +1 =
1 +τ
τ ~ ~
Lt + At ) (39)
Employment responds with a lag to shock to
productivity. Though the entrepreneur may want to employ
more workers as a result of higher productivity level as it
can generate more profit from that, it cannot because the
employment is subject to the entrepreneur’s present net worth
which depends on previously-acquired asset. However,
increase in productivity can boost next period’s employment
as it increases firm’s output and profit, even if the number of
workers is unchanged. It enables the firm to purchase more
assets. Therefore, net worth is higher in the subsequent
period and that enables the entrepreneur to borrow more to
hire additional workers. Moreover, such effect is persistent.
Though the shock to productivity lasts only one period, the
effect on employment and thus on output lasts much longer
and only dies out at the rate given by 1 +τ . If the shock to
productivity is serially correlated, this effect remains, so that
the collateral constraint prolongs the effect of the productivity
and Asset
profit purchase rises
Employment increaseis
Constraint Net worth
improves relaxed increases

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost

Experiment 2: Shock to Dividend ( D ) Likewise, t

assume that exogenous variables, except for dividend, remain

~ R −β ~ β~ ~ =  R − β ~
From q~ t + Rt =  Dt + Et q
 R  R
t +1 , we have q t R −β ρ
 D

Then proceeding as before, we have

~ τ ~ τ ~ τ ~  τ  R − β ~
Lt = et −1 + qt = et −1 +   Dt
1 +τ 1 +τ 1 +τ 1 +τ  R − β ρD 
~ τ ~ 1 ~ τ ~  1  R − β  ~
et = et −1 − qt = et −1 −  Dt
1 +τ 1 +τ 1 +τ  1 + τ  R − β ρD 

By combining, we obtain
Lt =
τ ~
1 +τ
Lt −1 + ε~t D ) (40)
Despite the fact that employment does not respond
immediately to productivity level, it can respond to dividend
shocks contemporaneously. Once there is an innovation in
dividend, change in asset price occurs and thus net worth is
revised in the period shock takes place. Then the entrepreneur
could adjust its labor demand in accordance with its net
worth. The positive shock to dividend results in an increase
in employment as the collateral constraint is relaxed. Besides,
like productivity shock, the effect from shock to dividends is
also persistent.

Positive Asset price Net worth

Dividend Shock rises increases

Constraint is

Output and relaxed

Asset purchase Employment
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rises improves
Nuwat Nookhwun

Experiment 3: Shock to degree of agency costs ( µ ) t

For example, when there is financial panic, the collateral

constraint is more severe. The firm will be lent much lower
than usual. On the other hand, if financial deregulation takes
place, the entrepreneur will be provided with more loans in
hand given the same value of collateral. To investigate such
shock, also assume other exogenous variables remain stable.
Then we have
~ τ ~ τ ~
Lt = µt + et −1
1 +τ 1 +τ
τ ~ τ ~
e~t = et −1 + µt
1 +τ 1 +τ
~ =ρ µ
µ ~ ~µ
t µ t −1 + ε t

By combining, we obtain
τ ~ + ε~ µ + τ L
Lt =
1 +τ
ρµ µt −1 t
1 +τ
t −1 (41)
Like dividend shock, shock to degree of agency cost
affects employment contemporaneously because such shock
alters firm’s ability to borrow and employment respectively.
Negative shock to degree of agency cost resulting in higher
µt enhances firm’s borrowing in the period shock occurs and
finally, employment improves. These effects are persistent
through two channels. The first channel operates through the

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
lagged effect of agency cost shock as the degree of agency
cost is serially correlated, thus it remains higher than its
steady state for some range of time, and benefiting firm’s
borrowing. Meanwhile, the other one involves continually
higher asset purchase resulted from increases in employment
and profit. Therefore, the effects are highly persistent. Lower
agency cost can result in a period of credit boom which
employment is benefited from that. On the other hand, the
positive agency cost shock, such as financial crisis, could
take times harming the economy before returning to a normal
Negative Agency
Cost Shock
is higher than
its steady state
Constraint is
for some range Net worth
of time. Employment increases
Output and ppurchase rises

profit increase

Experiment 4: A monetary policy shock ( R ) This


shock is generated from a change in central bank’s policy

interest rate.

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Nuwat Nookhwun
~ R −β ~ β~
From t +1 , we have q t = −Rt .
~ +R ~ ~
q t t = Dt + Et q
 R  R
αR ~ αR ~
And From µt +1 = ρµ µt − µ Rt +1 + εt +1 , we have µt = ρµ µt −1 − µ Rt
~ ~ ~µ ~ ~

Proceeding as before, we have

~ τ ~ τ ~ τ ~ τ ~ τ ~ τ  ~ αR ~ 
Lt = et −1 + qt + µt = et −1 − Rt +  ρµ µt −1 − µ Rt 
 
1 +τ 1 +τ 1 +τ 1 +τ 1 +τ 1 +τ  

~ τ ~ 1 ~ τ ~ τ ~ 1 ~ τ  ~ αR ~ 
et = et −1 − qt + µt = et −1 + Rt +  ρµ µt −1 − µ Rt 
 
1 +τ 1 +τ 1 +τ 1 +τ 1 +τ 1 +τ  

By combining, we obtain
τ ~  αR  ~ ~ 
~ ~
Lt =  Lt −1 + Rt −1 − 1 + Rt + ρµ µ
1 +τ  µ  t −1 
  

The effects from monetary policy shock are more

complicated than others. In summary, as suggested by
equation (42), there are both contemporaneous and lagged
effects. Expansionary
Monetary Policy
is higher than
Agency cost
Asset price
lowers its steady
state for
some range
of time.
Constraint is Asset
Adver f
relaxed. purchase
Output andfalls
Asset Employment Wage
purchase rises improves- 56 - increases
Output and profit
Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost

The contemporaneous one is generated as follow.

Assume that central bank implements expansionary monetary
policy. Lower interest rate increases entrepreneur’s borrowing
by lowering the degree of agency cost and raising the asset
price. That helps boost the present employment. However, its
lagged effect tends to lower employment because as labor
demand increases, there is a rise in equilibrium wage which,
in turn, negatively affects the present employment. There will
be less profit and asset acquired which depresses future
Beyond the interest rate impacts, there is also a lagged
effect from change in the degree of agency cost. Since the
process of agency cost is serially correlated, expansionary
monetary policy that lowers agency cost in the decision-
making period will keep agency cost low in subsequent
periods before returning to its steady-state. So, low interest

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Nuwat Nookhwun

rate can also trigger a credit boom and its effect on

employment will be highly persistent as well.

6. Optimal Monetary Policy

Now, we move to the most important part of this paper,

which is to find out the optimal monetary policy. As already
mentioned, the welfare criterion is method used to judge the
optimal policy. Here, the social welfare is the same as that
used in Carlstrom and Fuerst (2001A,B)
1 1
1+ 1+
τ τ
Lt Lt
Vt ≡ ct + cte −
= At Lt + Dt −
1 (43)
1+ 1+
τ τ
It is equivalent to the sum of the welfare of consumers
and entrepreneurs. Note that the entrepreneur has linear
preferences over consumption. The consumption by both
agents equals amount of output produced plus dividends
generated by asset. In this welfare function, labor is the only
factor to be chosen. In order to maximize the welfare of the
society, we obtain the following first-order condition
Lt = Atτ (44)
Carlstrom and Fuerst (2001A,B) called the above
outcome “the first-best employment”. However, this first-best
employment is not achievable because there is collateral

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
constraint in the world with imperfect credit markets. The
employment Lt = wtτ is left too low because w
t < At as a result of
such constraint. Importantly, it suggests that employment
should respond to productivity level, not to any other types
of shock. But, from the shock experiments above, the
contemporaneous employment does not respond to
productivity shock while responding to other types of shock.
Consequently, the collateral constraint causes the economy to
under respond to productivity shock, and over respond to
dividend and agency cost shocks. The economy really
responds inefficiently to shocks and that does not benefit the
social welfare.
Now we are interested if monetary policy can improve
on this economy’s ability to respond to shocks. As we have
learnt from the steady state that there is no unique optimal
long-run interest rate, monetary policy may have a role in
stabilizing the economy in the short run. The appropriate
adjustment that is welfare-improving occurs when
~ ~
Lt =τAt

Imposing this on the economy model (35)-(38), we can

then back out the implied interest rate policy. This optimal
policy implies the following behavior:
~ τ
τAt = ( µ~t + e~t −1 + q~ )
1 +τ

~ 1 ~ ~
At = ( µt + et −1 + q~ )
1 +τ

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Nuwat Nookhwun

Substitute (46) in (36) yields

τ ~ τ ~ 1 ~ ~
et = et −1 + µt + ( µt + et −1 + q~ ) − 1 q~t
1 +τ 1 +τ 1 +τ 1 +τ
~ =~
et e +µ
t −1
t (47)
The above equation implies that optimal policy must
keep ~
et equivalent to ~ ~
et −1 + µt

From (36), we have

~ ~ = τ ( e~ + µ
et −1 + µ
~ )+A 1 ~
t −1 t − qt
1 +τ 1 +τ
t t

~ = (1 + τ ) A
q t − ( e~ + µ
~ )
t −1 t

Substitute (48) in (37) yields

R −β ~
(1 + τ ) A~t − ( e~t −1 + µ~t ) + R~t
= Dt + Et
(1 + τ ) A~t +1 − ( e~t + µ~t +1 ) )
 R  R
~ R−β  ~ ~ ~
Rt =  (
 Dt + µ t + et −1 − (1 + τ )  )
 R − β ρA  ~
 At − Et µ
β ~
t +1
 R   R  R
αR ~ ~ µ
Substitute µt = ρµ µt −1 − µ Rt + ε t in the above reaction
~ ~

function yields

Rt =
µ +α(R − β)
 R − β  ~
( )
 R − β ρA  ~ β ~ 
 R  Dt + ρ µ µ t −1 + ε t + et −1 − (1 + τ )  R  At − Et R µ t +1 
~ ~µ ~
    
αR ~
Further substitute yields
~ =ρ µ
µ ~ ~µ
Rt +1 + ε
t +1 µ t − t +1

( )
 R− β  ~ ~  R− β A ~ 
  R  Dt + et− 1 − ( 1+ τ )  R  At 
~ µ     
Rt =
µ + α ( R − β − β µ )   R − β − β µ  ~ ~µ β ~ρ  ρ
( )
 +   ρ µ µ t− 1 + ε t + Et Rt+ 1
µ 
  R 

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
Assume that the discount factor and the autoregressive
coefficient are both low so that is always positive.
R − β − βρµ 23

I also simplify the above reaction function by ignoring the

response to expected change in policy interest rate in the
future because such variable primarily responds to future
value of shocks which is likely to be small as they follow
AR1 process and some types of shocks are stabilized by the
present monetary policy. Moreover, the response to future
policy rate is further discounted by µ , so it may be
insignificant that we could ignore.
From the policy reaction function above, equation (49),
there are some important findings concerning the optimal
monetary policy.
First, when there is a positive shock to productivity A , t

the central bank should lower the nominal interest rate so

that employment can expand in an efficient manner. A
constant interest rate policy does not allow this because of
the collateral constraint. This procyclical interest rate policy
overcomes the collateral constraint by making asset price and
the degree of agency cost procyclical, and thus allows the
economy to respond appropriately.
If it is negative, the policy response will be unjustified. For
example, the response to positive agency cost shock which depresses
the employment might be to raise the policy interest rate.

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Nuwat Nookhwun

Second, and in contrast, if there is a positive shock to

dividend D , the central bank should increase the interest rate

by enough to keep employment constant. It is inefficient for

employment to respond to this dividend shock, and the
central bank can ensure no response by raising the nominal
rate in response. In this case, the central bank increases the
nominal rate by enough to keep share prices lower.
Moreover, by responding in this way, the agency cost is
higher, which also helps lower the employment.
Third, in addition to productivity and dividend shocks,
the interest rate should also respond to shock to degree of
agency cost. If there is a negative shock which leads to
higher employment, the central bank should increase the
interest rate by enough to keep it constant. It is also
inefficient for employment to respond to agency cost shock.
However, the difference is that the interest rate in the
subsequent periods may also increase as well because there
are lagged effect transmitted through the future, but the size
of response for monetary policy will be discounted by ρµ .
Therefore, continually higher interest rate may be needed.
However, if the interest rate rises by enough to keep agency
cost at its steady state, it will not generate any lagged effects
and thus the future interest rate movement is not needed. On
the other hand, if there is a positive shock to agency shock,

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
for example, the financial crisis or panic, a continuously
lower interest rate policy should be implemented as it take
times for agency cost to return to its steady-state level.
Nevertheless, if the policy interest rate lowers by enough to
keep agency cost at the steady state level before the crisis or
panic occur, there will be no need for future course of policy
interest rate.
Fourth, there is an obvious danger to a policy with very
low average nominal interest rates or worse, near a zero
bound. The optimal policy requires an ability to move the
nominal rate adequately in response to shocks. As the
average nominal rate approaches the zero bound, this
flexibility is lost. In this model with collateral constraint, the
Friedman rule would be detrimental as the central bank

loses all ability to respond in the way implied by (49).

Fifth, central bank may not always respond to shocks as
suggested by (49). We have learnt previously that the first-
best employment is not achievable because of the collateral
constraint. Thus, there is an incentive to allow shocks to
occur without monetary policy response if such shocks lead
Friedman Rule implies optimal monetary policy requires that the
central bank simply set the nominal rate of interest to zero
independent of asset prices or any other shocks that might buffet the

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Nuwat Nookhwun

to higher employment. Therefore, positive shock to asset

price and negative agency cost shock that enable the
entrepreneur to borrow more to finance further employment
contribute to no monetary response at all until the first-best
employment is reached.
Sixth, the size of response to all shocks depends on the
effectiveness of the credit channel of the monetary policy,
which is represented by α . The reaction function above
suggests that the response by economies that have effective
credit channel of the policy or high α tend to be smaller than
the less effective ones. The intuition behind this finding is
that beyond its impact on asset price, the effect of the
interest rate can transmit effectively the credit channel of
monetary policy. Therefore, central bank does not need to
increase the interest rate by that much.
Lastly, the steady-state degree of agency cost can also
influence the size of response. We have learnt previously that
economies with low steady-state degree of agency cost (or
high µ ) tend to have low interest rate impact on credit
condition. Thus, they may need larger monetary policy
response to shocks. Meanwhile, economies with high agency
cost do not have to enormously adjust their interest rate in
response to shocks. Only a small-to-modest change in

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
monetary policy can provide significant impact on credit

7. Conclusions

This paper addresses one of the most controversial

issues for monetary policymakers during the last decade. It
concerns the role of monetary policy in responding to asset
price and asset price bubbles. By adopting the adapted
version of Carlstrom and Fuerst (2001A) model, the results
show that there is a welfare-improving role for a monetary
policy that responds actively to asset price, productivity and
agency cost shocks. This activist interest rate policy allows
the economy to respond to shocks in an efficient manner.
Under the world with imperfect credit market, monetary
policy cannot eliminate the long-run impact of the collateral
constraint. The economy cannot achieve its first-best
employment. However, it can improve welfare by smoothing
the fluctuations in this constraint. When there are shocks to
asset price and agency cost, it is inefficient for employment,
induced by fluctuations in net worth or collateral, to respond
to such shocks. Therefore, monetary policy must respond to
keep it constant. Moreover, the size of the response also

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Nuwat Nookhwun

depends on the effectiveness of the credit channel of the

monetary policy and the steady-state degree of agency cost.
Economies with effective credit channel and high agency cost
could react smaller in response to shocks.
The result that suggests monetary policy has a welfare-
improving role when responding to asset price shock is in
line with many theoretical literatures which support proactive
policy. Though most literatures are likely to include the
central bank’s loss function in their model, this paper is
almost different by using kind of micro-foundation approach.
But, the results are alike. The interesting point from this
result is that monetary policy responds to shock or movement
in asset price regardless that it is bubble or can be justified
by fundamentals. Effects of an upward movement in asset
price must be stabilized by tightening monetary policy while
a fall in asset price which depresses employment by lowering
firm’s net worth must be accompanied by expansionary
policy. In the results from Bordo and Jeanne (2002A,B), the
central banks also do not care whether asset price rise is an
event of bubble or not when selecting the appropriate
monetary policy response to the possible asset price reversal.
They insisted such reversal can harm the economy no matter
how the boom is caused by. In this paper, asset price

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
movement results in an inefficient dynamic of the economy
which monetary policy must act to stabilize.
In addition to asset price shock, shock to the degree of
agency cost requires monetary policy to respond counter-
cyclically as well. The model really proves the need to be
aware of agency cost shock because when shocks appear,
they can be highly persistent and contribute to a long period
of credit boom or contraction which inefficiently affects
employment and output. Therefore, the model can capture the
evidence in the real world where credit boom and bust can
trigger an unsustainable development of the economy.
Specifically, as discussed earlier, the credit boom, when
accompanied by asset price bubble, is a threat to the
economy. They could generate a collateral-induced credit
crunch, financial crisis, and eventually economic slowdown
when reversals occur. Thus, it is important for monetary
authorities to be aware of such coincidence. In the context of
this theoretical model, both affect employment and output in
an inefficient manner. If they occur simultaneously,
aggressive monetary policy tightening may be required to
control them. However, when there are reversals which lead
to asset price bust and credit crunch, aggressive monetary
policy must be implemented.

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Nuwat Nookhwun

The dependence of the size of the response on the

effectiveness of the credit channel of the monetary policy
also has an important implication. In the real world, the
effectiveness of the credit channel can alter in different
circumstances. In particular, when there is a financial crisis,
the credit channel seems to be ineffective. Credit extension
do not fully, or even marginally, respond to change in
monetary policy as financial risks and fragility keep financial
institutions reluctant to lend. As a result, in an absence of the
credit channel, a small-to-modest monetary expansion, say 25
to 50 basis point decrease in policy rate, during financial
crisis might be not enough to stimulate the economy.
Actually, it can be easily noticed that aggressive monetary
easing is used by most central banks to deal with the
aftermaths of subprime crisis. Many even continue lowering
their policy interest rate for many times. In order to measure
the effectiveness of the credit channel of the monetary policy,
explicit model of bank behavior is needed. The model would
tell us how banks or financial institutions make decision on
their amount of money lent. Other factors beyond net worth
of entrepreneurs would be considered.
However, though the model allows the coincidence of
credit boom and asset price bubbles, there is no interaction
between both of them. The possible extension of the model

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Monetary Policy and Asset Price under Time-varying Degree of
Agency Cost
should include the feedback loop Mishkin (2008) explains.
Credit boom and asset price bubble support each other in
their occurrence and pose significant risks to financial market
when their reversals take place. The role of such feedback
loop could make this theoretical stylized model more realistic
and have some implications for monetary policymakers in
making policy decisions. My view here is that under the
model with such loophole, if the coincidence occurred,
monetary policy might respond to it less aggressively as
reduction in asset price would help depress collateral-induced
credit boom and credit contraction, in turn, helps lower
demand for asset.
Moreover, it would be interesting if the future study
conduct a numerical simulation of the parameters in this
model. That would enable us to know the exact size of
policy response to shocks. We can also study an appropriate
policy response to shocks under different economies or the
same economy but with different circumstances. Recall that
one term in the policy reaction function has been assumed to
be positive. Thus, the numerical simulation would contribute
to a deep investigation of such term and actually, it might
turn negative in some cases.

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Nuwat Nookhwun

8. References

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Asset Prices, Economic
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Bordo, Michael, and Olivier Jeanne (2002B). “Monetary

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Monetary Policy and Asset Price under Time-varying Degree of
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