Relationship Between Asset Price and Monetary Policy

Relationship Between Asset Price and M sensationtary PolicyWith the development of capital commercialise and the innovation of finance, plus charges induce interpreted a to a greater extent(prenominal) prominent role in fiscal economy. Mean go, financial crisis and economy turbulences aro workout by abnormal pluss damage fluctuation appear in many countries. Currently, chinaware is confronted with the populace of plus expenses inflation. Asset scathes quickly fluctuation bought gigantic impact to fiscal insurance insurance, consequently, tryoutine the alliance between summation terms and fiscal form _or_ system of government harmonise to Chinas economy is of import.This dissertation applies correlation epitome, unit root audition, cointegration probe and husbandman former test in the empirical measuremary of the kinship between asset equipment casualty and monetary insurance, from the entropy analysis, we could conclude that asset tolls and mo netary indemnity withdraw a gigantic-term birth. The central commit building should focus on the role of asset worth on the transmit chemical mechanism of monetary form _or_ system of government.1. Introduction MotivationWith the development of modern capital securities industry and financial innovation, the world economy has into the financial economy era, and disappears increasingly capitalization, virtualization cuts. It is no doubt that modern capital market has provided a decent lever for frugal growth, unless its instability as well mictu station macro scotch fluctuations , and in particular the asset harm bubbles, which is becoming a key factor for financial crisis and scotch fluctuations.So far, the most developed Western countries fall in experienced a long period of rapid growth, concern is that global asset set has increase sharply in recent years. In the late 1980s, the striving market and veridical landed estate in Japan as the representative of asset prices have greatly increased ,which also ca physical exertiond Japanese economy into the bubble economy, the credit crunch and economic recession arising from the bubble economy have serious interdict effects so far. In 2006, the Dow Jones industrial average index in USA was beyond the highest point of network technology bubble expansion from 2000, the stock market of many other developed and emerging market countries generally strongly increased and was beyond history records. In addition to the security market , the global real number estate, capital and oil market are also very active. In 2001-2005, real estate prices have nearly doubled in many developed countries, meanwhile, real estate price in many developing countries has also generally increased. In May 2006, the international spot gold price stretched USD per ounce 718 score in New York City market since 1980. In mid-July 2006, the International crude oil futures price GE exceeded the highest record to r for eac h one 75 USD/barrel. But, inevitably brought the more serious financial crisis in 2007, which has caused huge economic fluctuations to the economy from 2007.In China, securities market have established for ten years, the shares of transpor plank securities in the structure of residents capital portfolios continued to be increasing, in 1992, the total value of Chinese stock market is 1048 billion yuan, accounting for only 3.9% of egregious domestic product (GDP) ratio . But in 2007, the stock market value is 327141 billion yuan, the ratio of market value in GDP has being greatly rising to 130% , which is 312 time growth compared with the total stock market value in 1992 . Not only a huge amount, but also the fluctuations of asset prices have become more frequent and intense. In 2006-2007, Chinese economy under the driven of stock market and real estate market has a reliable degree of asset price bubbles. While in the same time , Chinese economy is actually facing the reality of asset price falling from the top digit, shanghai security market falls rapidly from the peak position in 2007, the stock market bubbles fetch the extrusion, the real estate market similarly is also facing the similar situation, house price of major cities has falls obviously, the turnover falls into the valley.All of these financial crisis constantly are reminding people that the worldwide economic fluctuations are characterized by the financial instability , and economic cyclical fluctuations, instead of disappearing, and to be scrambleting worse, cause keepvasable economic depression, frequent asset price volatility and financial crisis and economic recession arising from the asset market collapse, hence , the government should focus on the asset prices on the role of macroeconomic fluctuations and the central margin in the world have to consider the information from asset price fluctuations. The Fed hot seat Alan Greenspan and Bernanke concern much nearly monetary policy a nd asset price volatility. Alan Greenspan proposed central intrusts should be more concerned ab come out the issue of asset price bubbles in the anniversary meeting celebrating the establishment of the Bank of England in 1994 . Chairman Bernanke is an internationally recognized as the founder of monetary policy and asset price research. At their encouragement , the international academic community and the national central banking concerns have recent research and debate whether the monetary authorities should intervene at once in asset price fluctuations. These research and debates are from the different backgrounds in different countries, in accordance with their different assumptions and premises, provide some signifi potce policy ad vice.Financial markets in particular capital market deepening and broad-based, and financial innovation enables financial institutions have diversity features. The boundaries of money and other financial assets is blurring, specie fork up and re al economic variable stars lost stability, the monetary policy impact on the real economy is no longer limited to traditional approaches, according to the traditional Keynesian theory, this impact on consumption and investment mainly through interest station variable . But as the improvement of financial system and increase of financial assets stock , monetary policy bum also use the wealth effect of asset prices and Tobin q to regard the consumption and investment, create the changes of total invite, in stick price, the hoard up demand led to a change in the output , and cause the effect of the output changes on demand, if the aggregate demand exceeds the aggregate supply ,it can lead to inflation pressures. This series of transmission mechanism make the role of asset market on the real economy become more prominent, asset price has become a major transmission channel of monetary policy .From the reality in China, the rapidly development of asset markets have a key role in ou r national economy, the impact of real estate market and stock market on economic and monetary policy are becoming increasingly apparent. In fact, the Chinese monetary authorities have also already begin to even off attention to the relationship of asset price and monetary policy . Xiaochuan, Zhou , as the Governor of Chinese central bank ,says that the central bank concerns about changes in asset prices and slacken offs full attention to information from asset price when formulating and implementing monetary policy. Therefore, study the relationship between asset price and monetary policy in Chinese economy is significant.This dissertation analyze the relationship of asset price and monetary policysystematically, and will use econometric methodology to look to to explore the relationship between asset price and monetary policy in China by using quarterly statistics from 1998 to 2008. I will approximation the relationship between monetary policy variables and asset price variabl es , through correlation analysis, unit root test, cointergration test Granger Causality test to get the conclusion. This dissertation conclude the results thatmonetary policy and asset price have a long-term relationship, in a short time, the monetary policy exacerbate the asset price fluctuations to some degree, the asset market appeared to be rapidly soared and shirked in a short period of time. The central bank should focus on the role of asset price on the transmit mechanism of monetary policy.2. Literature Review2.1 Empirical Studies from Western EconomistsThe research from western economists on relationship of asset price fluctuations and monetary policy mainly reflects the two views. First, asset price and monetary policy do not exist the causal relationship on behavior , and the only relationship is on the information that reflects the present and future output growth. Another view on research of asset price fluctuation and monetary policy is that asset price can affect co nsumption and investment through wealth effects , the change of capital follow and asset price fluctuations affect consumption and investment respectively through wealth effects and Tobin q, consequently affect the financial institutions status of assets and liabilities , further affect the stability of the financial system. It is evidently that asset price has become the transmission mechanism of monetary policy.Frank Smets (1997) is one of the economist who systematically analysis the best monetary policy that Central Bank should response on asset price change. He has proposed the following important viewpoint how the central bank should oppose to monetary policy reflecting the unexpected change of asset price, how this change affect the central banks inflation forecast. There are two factors affecting the central bank forecast inflation. First is that the effect of asset price on transmitting mechanism of monetary policy. Second is that the unique information on asset price. He established a simple macro-economic model that contains equation of Phillips curve, aggregate demand on financial asset prices (as represented by the stock price) , arbitrage and dividend , he uses this model to examine the variety of ways that change of financial assets price affect the real economy, and analysis the optimal monetary policy of central bank response to financial asset price movements. He demonstrate that the optimal monetary policy of central bank response to financial asset price movements, that is, according to the structure of established model , weighted average of the short-term interest rate ( traditional intermediary target of monetary policy) and asset price as price index monetary conditions index (MCI) , and regard this index as the target of monetary policy operations, therefore it can properly hunt central bank make effectively response on monetary policy to change of financial assets price.Gunnarsson and Lindqvist (1997) have discussed the role of asset price on monetary policy from the wealth effect on change of asset price and the effect of inflation. They conclude that the monetary policy should be given more attention on the change of asset price, although it is very uncorrectable to explain. They believe that the change of asset price affect monetary policy as long as this change is long-term change, and in recent years, the impact of this change of asset prices on the economic has been more and more important, so the central bank should spend more energy to analyze the relationship of asset prices and monetary policy, although this relationship is hard to explain but indeed existing. They believe that asset price as an power for monetary policy might contribute to the inflation forecast.B.Bemanke and M.Gcrtler (2000,2001) have provided that In an particular assigned situation , the monetary policy serve to the change of asset price is determined by if existing of the inflation or the deflation pressure on real economy or not, if this change of asset price do not bring the inflation or the deflation pressure on the real economy, then the monetary policy does not need to move to this kind change of asset price, but If this change of asset price indicates that it indeed brings the inflation or the deflation pressure on the real economy, then the monetary policy should make some response to alleviates this pressure. They propose the above policy seriously under the system frame of flexible currency inflation goal.Cecchetti, Genberg, Lipsky and Wadhwani (2000) have noted that how the central bank respond to asset price fluctuation mainly depends on the nature of the asset price fluctuation. When only have the wound of financial aspect on macro-economy, the central banks exchange rate policy should make an appropriate response, because doing so will avoid the financial shock on the stability of real economy . When the central banks target is to minimize the fluctuations of Inflation ratio and econom ic output gap to their target value , the central bank take possible action to eliminate the negative effects of financial volatility is a very good thing.2.2 Empirical Studies from Chinese ScholarsAfter the Asian financial crisis in 1997, the scholars in China have began to research the relationship between asset price and monetary policy. From a theoretical viewpoint, on the one hand, monetary policy have an impact on asset prices through the adopted operation scape, on the other hand, as a virtual asset relatively to physical asset , asset price fluctuations can also have some impact on peoples consumption and investment behaviour, hence, affect economic development through consumer and investment , further transmit monetary policy purpose to the real economy.Xiaoan Qian (1998) finds that change of asset price make a impediment in monetary policy transmission mechanism, this will cause the certain effects on monetary quantity management, inflation command and financial chance avoidance. The increase of asset price has been made transmission role of the monetary policy in the currency market change and become a blood of pedigrees in the asset markets, causing short-term funds long-term occupation , so that the transmission mechanism of monetary policy to occur difficulty. man of funds seperated from the bank system, directly to the virtual asset markets.Wenjun Xun (2000) believes that the development of capital market increase the number of the emerging non-bank organization such as retirement benefit fund, the mutual fund, the Insurance company and so on, the bank also participates in the competition of capital market , the effect of the capital market on the real economy gradually highlight, the transmitted mechanism of monetary policy increases, economic subject and its behavior are diversity, uncertainty about the economical movement increases, therefore the transmitted mechanism of monetary policy is more complex. They thinks that Central Banks monetary policy should manoeuvre official interest rate through the market , thus indirectly influence the bond and the stock market price in capital market, further influence real economy, achieves the monetary policy goal.Qiang Qu (2001) has found that it is difficult to put asset prices as the goal of direct control of monetary policy in the monetary policy operations, the possibilities and accuracy of establishment of general asset price index is very small, asset prices can only be used as an indirect reference, in short, to concern on it , but not target on it.Gang Yi and Zhao Wang (2002) have considered that monetary policy have impact on financial asset prices (in particular the stock price), the relationship of currency quantity and inflation not only depends on the price of goods and services, and in a certain degree depends on the stock market.Tianyong Guo(2006) has affirmed the role of asset price fluctuation on real economy , financial stability and monetary policy thr ough analysis, at the same time, he also points out that the asset price as regulatory targets exist difficulties.Chang Cui (2007) analysis the role of asset price on monetary policy through the model , in asset price inflation period, the central bank can take the measure of interest rate for a given period too control asset price fluctuation, and control the money supply when asset price bubbles exist will receive immediate effect. While in asset price downturn period , interest rate adjust asset price have obvious and relatively durable effect.Yuanquan Yu (2008) obtains through the empirical analysis the asset price has a certain influence on macroeconomic , particularly the effect of house price is more obvious. Therefore, the Central Bank must give the appropriate attention and control on asset price in the implement of monetary policy .In an conclusion, the asset price fluctuations have an certain impact on the ultimate objective of monetary policy, we can not ignore the uniqu e role of asset price on the transmission mechanism of monetary policy and the macro-economic activities. The central bank should concentrate on the effect of asset prices on monetary policy, particularly in asset prices fluctuations periods, the vast bulk of economists believe that the central bank should take an certain monetary policy to address and reduce the negative effect of the economy. For most of research focuses on the study of asset price fluctuation and its relationship with monetary policy, the role of asset prices in the transmission mechanism of monetary policy , as well as the effect size issues ,this dissertation based on the domestic and foreign scholar research results , deeply analyzes the transmitted mechanism of monetary policy in asset price through the impact of monetary policy on asset price .3. Data DescriptionThis dissertation focus on the relationship between asset price and monetary policy in China according to the quarterly statistics during the year of 1998 to 2008.This dissertation mainly use the stock price (index) and house price(hsp) as indicators of asset price , and use boarder money supply (m2), financial institution loanword (loan), real rate (rate) as indicators of monetary policy for simplicity. Due to the amount of the entropy of these variables are really great, we take log of these variables to analyze. This dissertation get all needed data from China frugal Information Network, which is a professionals institution engage in the development of economic data resources and services, provide data support, data integration, and other business data analysis for government and research institutions. All the quarterly data we need from 1998 to 2008 is recorded in the China Economic Information Network.3.1 Indicators for asset price in ChinaAsset prices generally including stock prices, bonds, prices, and even exchange rate, and other financial assets and house prices. However, the stock price and house price have a sign ificant effect on real economy, and its fluctuations can have a key role in monetary policy decision-making, hence, in this dissertation , we will use the stock price and house price refer to the asset price. In particular, the Shanghai securities composite index is on behave of the stock price for data limitations, Shanghai securities composite index is established by the Shanghai stock market to reflect the Shanghai securities trading market overall trend. House price is on behave of the average house price in China. We can easily get these data from the China Economic Information Network.3.2 Indicators for monetary policy in ChinaMonetary policy refers to the Government or the Central Bank influence economic activity, especially by money supply control and regulation of interest rates. To achieve a specific goal or maintain target for example, curbing inflation ,achieving full employment and economic growth, directly or indirectly through open market operations and setting the m inimum reserve rate. There are many factors needed to be consider in implementing monetary policy, for data restrictions, in this dissertation ,we mainly consider the variable of boarder money supply, financial institution loan and real rate.First, boarder money supply (lnm2) indicates the change of aggregate supply and pressure condition of inflation in the future. In china, boarder money supply is narrow money supply plus the saving, foreign currency and fiduciary deposits of government, organizations, services, businesses and institutions in financial institution. Boarder money supply can be used as a medium and long-term equilibrium target to regulate of financial markets .It is usually the rate of boarder money supply increasing should be controlled at the sum rate of economic growth and price inflation, monetary movement.Second, financial institution loan have some disadvantage as a indicators of monetary policy. First, it is fast associated with the monetary policy objective . Currency circulation and deposit currency caused by loan, the Central Bank control the size of the loan, which also mean to control the money supply. Second, financial institution loan is an accuracy an endogenous variable , loan size is substantiative correlation with loan demand. As a policy variables, loan size and the demand also have a imperious correlation. Furthermore, data of financial institution loan is easily accessible .Third, real rate refers to the real rate of interest return that the depositors and investors can get after eliminating of inflation rate, it is calculate as nominate rate minus CPI. Real rate can be used as the indicator of Central Banks monetary policy due to following reasons (1) real rate reflect the supply of money and credit, and able to memorialise the relative supply and demand, it is correlation with nominal interest rate ,High level of interest rate is thought to be a tight, low interest rate level of convergence are considered monetary re laxation. (2) real rate belongs to the Central Bank , the Central Bank can use this tools to increase or slump in interest rates. plank 1 denotation for VariablesdenotationVariablesImplicationLnindexShanghai securities composite indexShanghai securities trading market overall trendLnhspHouse priceReal estate priceLnloanLoanfinancial institution aggregation loan domesticLnm2M2boarder money supply M2+M1 investReal ratenominate rate minus CPI.4. Economic Theory and Econometric ModelThe effectiveness of monetary policy depends not only on the sensitivity of economic subjects on policy signal , but also on numerous external factors of financial system. According to the traditional Keynesian theory, when implementing expansionary monetary policy, increase of money supply will lead to rate decline, i.e. capital costs decreasing, further increasing investment expenditure, hence increasing aggregate demand and aggregate output. Meanwhile, increase of money supply will lead to the bank reser ve and deposit increase, thus enhanced bank to increase the loan quantity, the fund that the borrower attains increase, then the total quantity investment will increase, which also lead to the quantity of aggregate demand increase, hence, the total output also rise. We will use following econometric model to analyze the relationship of asset price and monetary policy.4.1. Analyzing correlation coefficientThe correlation coefficient is a measure of two variables relate to each other and their close degree of effective tools. Its absolute value is close to 1 description of relevance, the stronger between variables, the more its relevance with 0. If the correlation coefficient is positive, then the variables presented to changes in the relationship, with one variable with another variable changes. But if the correlation coefficient is negative, then the variables are changes in the relationship in the opposite direction. Using correlation coefficient can be better measured variables an d between monetary policy and asset price correlation between Extent its positive and negative symbol can indicate the variable ask changes direction. Generally used to be associated matrix said.4.2. essaying for NonstationaryIn time series, stationary is a key concept, as it allows powerful techniques for modelling and forecasting to be developed. Stationary is generally regarded as some pattern of data stable or equilibrium. Stationary time series have constant mean and variance, but its covariance only determined by the time distance. However, when time series could not analyze as stationary, this types of time series ever so have a strong upwards or downward trend over time, we call it as nonstationary, and we can use differencing as an effective tool to transform a nonstationary time series into a stationary time series. Sometimes, Transforming a nonstationary time series into a stationary one needs more than once differencing operation. Generally speaking, if the differencin g needs to be operated at least d times to achieve a stationary time series where d is the govern of integration, then the time series is said to be integrated of order d, denoted by I(d). Hence, the I(1) time series also referred to have a unit root, while the I(0) time series are stationary.Dickey and Fuller (1979) provided an effective method to test a time series is stationary or nonstationy time series, which is also called as Dickey-Fuller (DF) test. The elementary object is to test the vigour hypothesis that the time series have a unit root or not. The model the Dickey-Fuller (DF) test involves bellowsIn this dissertation , indicates the variables on monetary policy and asset price at time t. denotes unknown parameter and denotes the trend. denotes the first difference which . Also, the t-statistic for exam the null hypothesis that H0 =0 against the alternative hypothesis H1 While the index and real rate variable we consider under the model H0 against H1We also can identi fy the fittest chuck out k by running the ADF(k) test, choosing the fitted order k that gives the minimum AIC and BIC.4.3 CointegrationFormally, Engle and Granger (1987) defined the cointegration as if there exists a linear junto of two or more I(d) time series which is I(d) with dIn practice, we usually use cointegration test to exam the long-run relationship among variables in economics. If times series have relationship between variables, and the trend of the two time series has been common, and thus there will be a linear conclave of these time series give us an stationary time series.In this dissertation , we test the long-run relationship between monetary policy variable and asset price variable by cointegration test .First, we consider the regression of two I (1) time series. The model isTo test and are cointegrated, we need to exam that the residuals term is stationary .If the residuals term is I (1), then this two times series do not have a cointegration, otherwise , if the residuals term is I (o), then this two times series are cointegrated. Under this case, to test the residuals for unit root ,we can conduct DF/ADF-statistic test.In this paper, we denote that monetary policy variables as and we regress on a constant and one of the asset price variables as .4.4. Causality TestGranger (1969) provided that Granger spring test can apply generally for testing the causal relationship on two time series.Granger causality means that if Granger causes then have a predict power of , given any other variables. More formally, it is said that Granger causes when the forecast of given data on and outperforms the forecast of given data on only. Granger causality is only related to the predictability of using and is not concerned as to whether causes , it could be that Granger causes but is not causal for ,and vice versa.To test for Granger causality, we could estimate the regression by OLSIn this dissertation , denotes an indi cator of asset price, i.e. Shanghai composite index (lnindex) , house price ( lnhsp) , Also,denotes the indicator of monetary policy, i.e. financial institutions aggregate loan (lnloan), broad money (lnm2), real interest rate (rate) .Then conduct an F test on the null hypothesis against the alternative at least one of the is not zero. If we reject the null hypothesis, then has predictive power for and therefore, Granger causes , on the other hand, if we take apart to reject the null hypothesis, then has no predictive power for , therefore, does not Granger causes .We usually test the two times series for Granger causality in pairs, that is, first test whether Granger causes and then test whether Granger causes .If two variables have Grange causality relationship in both directions, i.e. Granger causes and Granger causes , then we could regard these two varibles have causality relationship in both directions, that means these two variables are related. If t wo variables have Granger causality in one direction, e.g. Granger causes but does not Granger cause , then we can conclude that these two variable just have a one way causality relationship.5. Presentation and Interpretation of Results5.1. correlation coefficient between monetary policy variables and asset prices variablesWe analysis the correlation between monetary policy variables and stock prices variable according to the data provided by China Economic Information Network, and the correlation coefficients are presented in Table 2 and Table 3.Table 2 Correlation coefficient between lnindex and lnloan,lnm2,rate in 1998-2008LnindexLnloanLnm2RateLnindex1.000000Lnloan0.48291.000000Lnm20.48670.99801.000000Rate-0.4717-0.9013-0.90671.000000As we can see, stock price (Lnindex) has correlation relationship with all monetary policy variables. With a higher stock price, loan and money supply will be increased, while real rate will be decreased. For monetary variables, loan and M2 ha ve a strong positive correlation, and M2 have a strong negative correlaton with real rate. In conclusion , for the stock price variable, it has basically the positive correlation with the loan and money supply variables , and has negatively correlation with the real rate.Table 3 Correlation coefficient between lnhsp and lnloan,lnm2,rate in 1998-2008LnhspLnloanLnm2RateLnhsp1.000000Lnloan0.96671.000000Lnm20.96330.99801.000000Rate-0.8453-0.9013-0.90671.000000From table 3, we can see house price (Lnhsp) has correlation relationship with all monetary policy variables. With a higher house price, loan and money supply will be increased, while real rate still will be decreased. In conclusion ,for the house price variable, it has basically the strong positive correlation with the loan and money supply variables , and has strong negatively correlation with the real rate.5.2.Results for unit root testWe exam monetary policy variables and asset prices variables by Augmented Dickey-Fuller (ADF) to test the stationary of time series. First ,we choose the AIC and BIC to determine the fitted lag it suggest that the optimal lag for time series is lag k =1,Then we run ADF to test stationary of time series. Results are belowTable 4Augmented Dickey-Fuller Unit Root Test for VariablesSeriesADFTest critical valuesResults5%1%Lnhsp-1.685-3.41-3.96have a unit rootLnindex-2.085-2.86-3.43have a unit rootLnm2