example, (Cecchetti, Genberg, Lipsky, and Wadhwani 2000) and (Dupor 2005).
However, there is disagreement on whether policymakers should target asset
prices because of the uncertainty concerning the nature of the forces driving
asset prices. Some authors argue that uncertainty concerning the magnitude
of misalignments in asset prices is not trivial and that it might imply that the
welfare benefits from including them in the policy reaction function may vanish
very easily — see, among others, (Gilchrist and Saito 2006), (Alexandre and
Bacao 2005) and (Tetlow 2004).
In this paper, we use (Dupor 2005)’s DSGE model with capital accumulation
and adjustment costs to evaluate the performance monetary policy rules in
stabilising the economy. This model, described in the next section, was developed
to study the optimal response of monetary policy to asset prices when agents
cannot discern the nature of the shocks that move asset prices. In Dupor’s
model, expectations of future returns to investment may be affected by unwarranted
views about future productivity, resulting in “irrational exuberance” and overinvestment.
In this paper, we add an additional source of uncertainty to Dupor’s setting.
The additional uncertainty affects the behaviour of asset prices via a Markov-switching
autoregressive coefficient in both fundamental and non-fundamental shocks.
We therefore assume a Markov-switching process, with booming periods of
continuous growth in asset prices being interrupted by sudden corrections,
aiming to capture the complex behaviour of financial markets.
This setting allows us to compare the performance of Taylor-type rules with
the optimal policy, when firms and policymakers face uncertainty concerning
the driving forces of asset prices and the moment when bubbles in asset prices
will collapse.
In the next sections we provide a more detailed analysis of the model and
of the monetary policy framework we use in our analysis.