Asset prices, financial conditions and the transmission of monetary policy

In this paper we assess the role of asset prices as information variables for aggregate demand conditions and in the transmission of monetary policy. A Monetary Conditions Index, a weighted average of the short-term interest rate and the exchange rate, has commonly been used as a composite measure of the stance of monetary policy and aggregate demand conditions. However, other asset prices, property and share prices, also affect aggregate demand. By looking at reduced form coefficient estimates and VAR impulse responses we derive Financial Conditions Indices, a weighted average of the short-term real interest rate, the effective real exchange rate, real property and real share prices, for the G7 countries. We find that house and share prices get a substantial weight in such an index and that the derived Financial Conditions Indices contain useful information about future inflationary pressures.