Abstract:

This paper uses a small open economy model that allows for the effects of asset price changes on aggregate demand and inflation to investigate the role stock price bubbles and exchange rate changes have played in the conduct of monetary policy in Canada. It argues that the Bank of Canada, in pursuing its primary objective of price stability, should respond to stock price bubbles and exchange rate changes irrespective of the policy regime. Estimates of the policy rules derived from the money growth targeting and inflation targeting regimes provide evidence that the Bank of Canada has systematically responded to stock price bubbles and exchange rate changes. This is consistent with the fact that estimates of the structural model indicate that stock price bubbles and exchange rate changes have significant effect on aggregate demand and inflation. I then use counterfactual simulation analysis to determine the benefit from responding to stock price bubbles and exchange rate changes. The results imply that responding to these asset price changes leads to lower average inflation and interest rates, but at the cost of increased volatility in both variables.