Monetary Policy and Asset Prices: More Bad News for ‘Benign Neglect’^*

Abstract

Abstract In this paper we explore the optimal policy reaction to boom–bust cycles in asset prices. Bordo and Jeanne (2002a, b) point to the risks of a reactive strategy that only mitigates the consequences of a crisis if and when it occurs. Acting pre‐emptively by rigorously counteracting the build‐up of the crisis scenario may be superior in welfare terms. We show that even a purely reactive monetary policy must involve an ex ante response to a possible asset price crash. The reason, however, is not the attempt to avoid real and financial disruption but to react optimally to changes in the private sector's expectations. Furthermore, we find that the welfare losses of a reactive strategy increase when forward‐looking expectations are taken into account, while the welfare implications of a proactive strategy do not change.