Monetary Policy and Asset Price Channel: Recommendations for the Policy Makers of Developing Countries

Abstract

Given the lack of strong institutional framework and relatively unstable political situation in developing countries, it is very essential to come up with a different and suitable monetary policy for those countries. A longstanding macroeconomic issue is how monetary policy affects the real economy. Asset price channel is one of the most important channels of monetary transmission mechanism. In this study, we explored the asset price channel of monetary transmission mechanism in a developing country’s setup. We carried out our analysis in the framework of Vector Auto Regression while taking account of all the limitations of time series data. Our benchmark model accounts for simultaneity and interdependence among variables. We tested for both short and long term relationships. Our data set contains quarterly data for twenty years. We applied Johansen Co integration test, Vector Error Correction Model and Granger causality. We came across some puzzling and alarming results.  Our analysis reveals that stock prices have a negative long run relationship with investment and output while it is generally expected that a tight monetary policy is linked with decrease in prices.  This kind of puzzling results should be taken into consideration by the central bank. Further, the analysis of the long term relationship between investment and other variables reveal that there is negative long run relationship between investment and interest rate; therefore, the central bank should be cautious while taking monetary policy actions. Interest rate is not causing any of the variables included in the asset price channel which means that interest rate is a weak policy tool as for as its effect in the asset price channel is concerned.

Keywords: Asset price channel, monetary transmission mechanism, money supply, stock prices, economic policies.