Nuwat Nookhwun, Monetary Policy and Asset Price under Timevarying Degree of Agency Cost

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Monetary Policy and Asset

Price

under Time-varying Degree of

Agency Cost

Nuwat Nookhwun

Research Paper,



Nuwat Nookhwun

Academic Year 2008

The Faculty of Economics,

Chulalongkorn University, Thailand

March 2009

Monetary Policy and Asset Price under Time-varying Degree

of Agency Cost123

1 This paper was written as a part of “Research Paper” subject, taught

in the bachelor’s degree at the Faculty of Economics, Chulalongkorn

University, in the academic year 2008.

2 This paper is an individual study. Any views or findings from this

study do not reflect those of the institutions

3 I would like to thank Pongsak Luangaram, Ph.D. from Warwick

University and lecturer at Chulalongkorn University, for a kind

assistance as an advisor of this paper. He helped me a lot in guiding

the appropriate topic, commenting on the model, and suggesting many

interesting arguments concerning the topic. Moreover, I do admire his

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Monetary Policy and Asset Price under Time-varying Degree of

Agency Cost

Nuwat Nookhwun

March 2009

ABSTRACT

The on-going subprime crisis has again raised the issue

of whether central banks should use monetary policy to

prevent asset price bubble. This paper presents an adapted

version of the theoretical model used by Carlstrom and Fuerst

(2001A) to address this issue. The model is constructed

under the assumption of imperfect credit market which the

entrepreneur’s net worth can affect its ability to produce. The

net worth, in turn, is determined by asset price. The

adaptation of the model involves the assumption that the net

worth is not the only factor determining the firm’s borrowing.

It also depends on the current degree of agency cost. This

paper regards this degree of agency cost as measure of credit

boom and bust.

The results show that there is a welfare-improving role

for a monetary policy that responds actively to asset price,

productivity and agency cost shocks. This activist policy

allows the economy to respond to shocks in an efficient

manner by smoothing the fluctuations in the collateral

dedication in studying and lecturing monetary economics.

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Nuwat Nookhwun

constraint. Moreover, the size of the response depends on the

effectiveness of the credit channel of the monetary policy and

the steady-state degree of agency cost.

Nuwat Nookhwun

112 Soi Areesampan 2

Paholyothin Rd., Bangkok,

Thailand 10400

[email protected]

Monetary Policy and Asset Price

under Time-varying Degree of Agency Cost

Nuwat Nookhwun

March 2009

1. Introduction

The on-going subprime crisis has again raised the issue

of whether central banks should use monetary policy to

prevent asset price bubbles; the issue that is still controversial

and challenging to all central bankers. However, it is

different this time. The impact of the collapse of house price

bubble occurred in the United States is so severe that many

considered it the most severe economic crisis since the Great

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mailto:[email protected]

mailto:[email protected]




Agency Cost

Depression in the 1930s. The bursting bubble led to a rise in

mortgage delinquency and foreclosure which contributed

many financial institutions to write down their loss from

default and an investment in mortgage-backed securities

(MBS) and collateralized debt obligations (CDO). Financial

crisis eventually occurs, and fear of recession spreads all over

the world. Apart from the role of securitization, poor

performance by credit-rating agencies and lack of regulation

in subprime mortgage market, monetary policy is to be

blamed for that.

The Federal Funds rate was held too low for a long

period with the objective to overcome the recession that was

caused by the burst of DOTCOM bubble together with theterrorist attack both in the early 2000s. The unusually low

U.S. policy rate caused excessive liquidity and a speculation

in housing market which subsequently led to a bubble. Taylor

(2007) points out that by slashing interest rates by more than

the Taylor rule suggested, the Federal Reserve (FED)

encouraged a house price boom. Though FED has started

increasing the rate since the second quarter of 2004, such

tightening should be implemented since 2002. With a higher

Federal Funds rate, there would have been a much smaller

increase in housing starts. Moreover, Manchau (2007)

suggests that “it is time to learn that main lesson of this

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Nuwat Nookhwun

crisis, which is that credit matters for monetary policy, a fact

over which many central bankers are still denial.” The closer

a real interest rate gets to zero, the greater the incentivesbecome for people to take on large amounts of debt. He also

interestingly mentioned that many central banks encountered

a dilemma during an onset of the crisis as a low inflation

and a rising house price bubble occurred simultaneously.

Eventually, the central bank that attempted to prick the

bubble, e.g. Riksbank, unlike FED, could escape the crisis.

Both authors above view monetary policy as a cause of

the present economic disruption and seem to support the role

of monetary policy in responding to the asset price bubble.

However, a number of prominent economists still disagree

with the proactive role. The reasons are not different from

what have been debated for a decade. They include, for

example, the difficulty in identifying bubble, ineffectiveness

of the monetary policy in dealing with it, and limited cost of

bursting bubble on the economy. In Kohn (2008), though he

believes that central banks can identify whether the asset

price rise is warranted by fundamentals, it is still difficult to

identify in a timely manner. He also argues that small-to-

modest policy actions might not be enough to contain

speculation. The only argument supporting the role of

proactive policy concerns the effect of the bursting bubble as

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Agency Cost

it can be far more painful than what he has previously

imagined. Mishkin (2008) also suggests monetary policy

respond to asset price movement, whether bubble occurs or

not, if and only if it has implications for inflation and output.

Apart from those reasons made by Kohn, he believes

monetary policy actions are a very blunt instrument because

they would be likely to affect prices in general, rather than

those in a bubble. That creates a further distortion in the

economy. Besides, he supports regulatory policies and

supervisory practices to help strengthen the financial system

and reduce its vulnerability to asset price cycle. Indeed, his

view is in accordance with the present FED governor, Ben S.

Bernanke.Therefore, the continually debating issue of whether

monetary policy should respond to asset price and asset price

bubble is still controversial nowadays. This paper presents an

adapted version of the theoretical model used by Carlstrom

and Fuerst (2001A) to address this issue. The model is

constructed under the assumption of imperfect credit market

which allows the linkage between the movement in asset

price and output. Under imperfect credit market, the amount

of funds each entrepreneur received is restricted to its

financial position which is represented by “collateral” or “net

worth”; consequently, increase in its asset price will increase

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Nuwat Nookhwun

the collateral and firm’s ability to produce respectively.

Welfare criterion will be used to judge whether monetary

policy should have a role in this imperfect world.In the subsequent section, I will again review arguments

concerning the role of monetary policy in dealing with the

asset price bubble that are made throughout a decade. Then, I

will discuss the role of credit in the forming of the bubble

and how the policy should react which are also important

issues as the bursting bubbles that severely affect the

economy are often associated with the credit boom. This

enhances the use of the model that includes the credit

channel when studying the consequence of the asset price

movement. The theoretical model will next be discussed and

several experiments will be conducted before eventually,

optimal monetary policy be solved. The last section will

provide you a conclusion.

2. Debates over Asset-Price Bubbles and

Monetary Policy4

4 Debates in this and the following sections are primarily summarized

from the following literatures: Bernanke (2002), Kohn (2006, 2008),

Mishkin (2008), Posen (2006), Roubini (2006) and Trichet (2005).

Most of them have negative views in attempting to contain asset-price

bubbles.

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Agency Cost

Basically, as introduced by Kohn (2006, 2008) there

are two strategies having been proposed for dealing with

market bubbles. They are “conventional strategy” and “extra

action.” Conventional strategy involves responding to asset

prices, e.g. stock or house price, only insofar as they have

implications for output and inflation over the medium term.5

This strategy includes “mopping up after” the bubbles have

already exploded. It is believed that if monetary policy

responds immediately to the decline in asset price, the

negative effects from a bursting bubble are likely to be small.

On the other hand, extra action attempts to damp speculative

activity by tightening monetary policy above and beyond

what the standard Taylor rule suggests. However, taking extra

action would entail some costs, creating higher

unemployment and lower inflation than would be desired.

Thus, this strategy involves trade-off worse macroeconomic

performance today for the chance of better performance in

the future. It is also known as “Proactive”, “Preemptive”, or

“Leaning against the wind” policy.

5 See Mishkin (2008) for an explanation of how asset prices interrupt

inflation and aggregate economic activity.

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Nuwat Nookhwun

As stated in the introduction, the debates over which

strategy is the most appropriate has not yet reached a final

round. A number of arguments made by supporters of bothstrategies are so convincing that challenge central bankers’

ability to choose a proper policy if next asset price bubble

occurs. I will begin here by introducing economic distortions

created by the bubbles that support the use of the proactive

policy.

In Cecchetti (2004), he states that the asset price

bubbles cause damages to entrepreneurs’ investment

decisions, households’ investment and saving decisions, and

the government’s fiscal policy decisions. For firms,

unjustifiably high equity prices make it too easy to obtain

financing. Internet companies can raise large sums of money

in equity markets in the 1990s during the onset of DOTCOM

bubble, which was to crash several years later. The funds

they used could clearly have been better invested in a more

productive sector. Concerning consumers’ behavior,

individuals feel wealthier during asset prices rise. More of

their income is spent while their saving fades away. When

the bubbles eventually burst, wealth is recomputed and

consumers are left with houses and mortgages that are too

large for their paychecks, and investment accounts that are

shadows of what they once were. Government financing

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Agency Cost

decisions are also distorted. As equity prices rise, tax

revenues tied to capital gains go up. Increased government

revenue leads to increases in expenditure and cuts in taxes.

With the bubble burst, tax revenues have fallen dramatically.

However, it is impossible to raise taxes, and the result is a

combination of expenditure cuts and increased borrowing, and

ultimately a fiscal imbalance.

Apart from those distortions, bubbles can cause financial

and real economic instability when they burst. Asset prices

can affect value of collateral and thus the provision of credit,

thereby influencing aggregate spending. In case of sharply

falling market valuations, these adverse credit-channel effects

may even be exacerbated by the deteriorating health of banksand other financial institutions. The on-going subprime crisis

is obviously a good illustration. Therefore, because economies

often fare very poorly after bubbles burst, central bankers

may attempt to control such bubbles to avoid such severe

crisis.

Though bubbles can cause damages to economic

decisions, and financial and real economic stability, there are

reasons why monetary policy should not be used in dealing

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Nuwat Nookhwun

with such bubbles.6

The major one among opposing views

involves the difficulty in identifying the bubbles. It is

difficult to say confidently whether the asset price rise can bewarranted by fundamentals or not since not all the

fundamental factors influencing asset price are directly

observable.7

Thus, any judgment by central banks that assets

are over priced is unavoidably highly uncertain. Mistakenly

identify the bubbles may result in significant costs as

mitigating a non-exist problem reduces real economic activity

and inflation below their desired level. Kohn (2008) tells us

that during the onset of the subprime crisis, staffs throughout

FED examined whether house prices were over valued and

arrived at a wide range of answers which kept them

unconfident that bubbles were already in progress. So, they

remained its conventional strategy. A variation of this

argument is how the FED can be a better judge than markets

about the existence of bubbles. If bubbles occur, market

participants should be the first one to recognize.

6 This paper summarized 3 opposed arguments based on Kohn (2006,

2008). See those literatures for details and development of those

arguments. 2008 speech revisited the same issue as a result of the

subprime crisis.

7 See Bernanke (2002) for possible indicators of fundamental value.

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Agency Cost

However, given that central banks could identify the

bubbles confidently and market participants would not

quickly arbitrage those mispricing away8, timing is still an

issue. Given the lags in the monetary transmission and

uncertainty about the duration of bubbles, raising interest

rates might actually risk exacerbating instability. The

resulting contraction effects on the economy would occur just

when the adverse effects of the bubble collapse are being

realized, worsening rather than mitigating the effects of the

bubble collapse. The policy really does nothing to influence

speculative activity.

Moreover, Bernanke (2002) points out an interesting

argument concerning that after identifying bubbles, centralbanks need to substitute their judgments for those of the

market. The negative consequence is that their attempt to

substitute their judgments can affect long-run stability and

efficiency of the financial system. Such attempt would only

increase the unhealthy tendency of investors to pay more

attention to rumors about policymakers’ attitudes than to the

economic fundamentals.

8 See reasons in Kohn (2008). Kohn also believes that events of latest

house price bubble made him little less dubious that policymakers can

reliably identify a serious bubble before it bursts, but timing still

matters.

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Nuwat Nookhwun

Nevertheless, proponents of the proactive policy might

counter-argue this identification matter. Roubini (2006)

argues that most theoretical models suggests uncertainty aboutthe occurrence of bubbles does not qualitatively change the

nature of optimal policy decisions that it should react to asset

prices in addition to output and inflation gap. Even if

monetary authorities cannot separate with certainty the two

components of an asset price, bubble and fundamental, the

optimal policy response implies reacting to the overall asset

price. The greater the uncertainty, the less the policy will

react to that variable. No response is, exactly, not a solution.

Actually in practice, central banks always face with

uncertainty in implementing policy. There are, for example,

data, parameter and model uncertainties. However, central

banks do not drop inflation or output from their

considerations because it is hard to estimate potential output

and expected inflation in rapidly changing economic structure.

So, there is no reason to ignore asset price bubbles as result

of an inability to identify them with confidence.

Another important reason by the critics of proactive

policy concerns the ability of monetary policy to influence

bubbles. They believe that in order to prick bubbles, the

monetary policy response would need to be large enough that

may lead to a recession and create greater damage than

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Agency Cost

potential harm bubbles generate. As a bubble is rising,

investors expect very high returns from the increase in asset

prices, sometimes as high as 100% per year. Therefore, a

modest increase in short-term interest rates would have a

limited impact on irrationally exuberant investors. Moreover,

central bank is truly not the only source of liquidity. In the

almost-perfect credit market, investors can depend on external

funding. As a result, aggressive tightening policy may be

needed and that makes ‘‘safe popping’’ impossible because

there is the risk of throwing the whole economy into

recession. Critics of bubble pricking often presented the

example of the 1929 stock market crash which the tightening

monetary policy rapidly led to market crash and dragged theeconomy down.

9Therefore, “mopping up later” might be a

better policy.

Many conventional economists also refer that “monetary

policy actions are a very blunt instrument” as there are many

asset prices, and at any one time a bubble may be present in

only a fraction of assets. So, policy actions would be likely

to affect asset prices in general, rather than solely those in a

bubble. Mitigating capital misallocating in one sector would

9 Some economists believe that the stock market decline was more the

result of developing economic weakness (and tight money) than the

cause of the slowdown. See Bernanke (2002) for details.

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Nuwat Nookhwun

have created misallocating elsewhere. Assenmacher-Wesche

and Gerlach (2008), using a panel of 17 OECD countries,

confirms that monetary policy is really empirically too bluntan instrument to be used to target asset prices since the

authors found that the effects on real property prices are too

small, given the responses of real GDP, and they are too

slow, given the response of real equity price. Thus, in

attempting to prick house price bubble, the well-functioning

stock market may crash in advance, and much of GDP must

be traded-off.

In addition, Posen (2006) cites in his paper that some

researchers failed to find any robust connection between

liquidity and growth in asset price. By studying asset price

boom in OECD countries, only one-third of monetary ease

leads to bubbles. The other illustration is from Japan’s

experience. As early as 1987, BOJ started expressing doubts

about bubble and even started raising interest rate. However,

the great bubble went on building until January 1990.

Supporters of preemptive policy might oppose by

mentioning that a monetary policy that reacts to asset bubbles

does not need to lead to severe economic contraction.

Roubini (2006) states that in any asset bubbles, there are

elements of a credit boom, reaching for yield, increasing

leverage and increasing and excessive risk taking by

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Agency Cost

investors. All these economic and investment decisions do

depend on interest rates and the stance of the monetary

policy. Therefore, the interest rates can affect both credit

conditions and the economic decisions that, in turn, affect

asset prices. The recent experiences of housing bubble in

early 2000s in the United Kingdom, Australia and New

Zealand also suggest that it is possible to react to bubbles

with a moderate and gradual monetary policy tightening

without causing a financial and economic crash. The soft

landing of those economy was so successful.

Indeed, the examples cited by the critics of preemptive

policy, such as Bernanke, are all cases in which the asset

bubble policy management was terrible. In Japan in the1980s, the Bank of Japan waited too long to deal with the

housing and equity bubbles and too long to ease to deal with

aftermaths. The case of Japan is similar to the US case of

1929 which is a classic example that the FED did not

respond immediately after one official signaled occurrence of

bubbles. Also, in the 1990s technology bubble, the monetary

easing was probably excessive and could reverse earlier and

faster. A less ‘irrationally exuberant’ Greenspan, an earlier

Fed policy of tightening and the use of other instruments to

control leverage could have had an effect on the bubble.

Moreover, most recently, as Taylor (2007) finds out,

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Nuwat Nookhwun

subprime crisis was also partially caused by too low interest

rate for a long period. The reverse of the policy rate was not

quick and high enough. At that time, though Greenspanalarmed seriously about housing bubble since 2005, he also

thought that central banks could not successfully target the

bubbles.

Apart from identification and policy effectiveness issues,

the other opposing argument by conventional supporters is

that the effect caused by bursting bubbles is limited . Risk-

averse policymakers might not regard the expected return

from extra action insurance as worth its premium. Posen

(2006) mentions that bubbles can do harm to the economy

only when there is financial fragility, especially in the case

when collateral interact with the provision of credit through a

banking system. One can imagine circumstances under which

an asset price bust could lead to a protracted recession. The

size of such negative effects in practice importantly depends

upon structure and condition of the financial system at the

time of the asset price shock. Thus, well-capitalized and

properly supervised banking systems tend to keep the

economy resilient to shocks. It can be inferred, however, that

bubbles’ damage to the economy is really not a monetary

issue, but an issue of financial structure and supervision.

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Agency Cost

In the high-tech boom, for example, the U.S. financial

system remained healthy after the collapse. That obviously

mitigated the real effect caused by bubble burst. In contrast,

the Great Depression in the United States, like Japan’s Great

Recession, did not arise immediately following the asset price

bust because severe banking system distress was combined

with damagingly tight monetary policy over years that output

declined. Kohn (2006) mentions accordingly that the

nonlinear risks associated with a collapsing bubble may

depend on the initial health of the financial system.

Prudential supervision in advance and prompt action to clean

up any problems afterwards would be better way to deal with

bubbles.Moreover, market corrections can also have severely

adverse consequences if they lead to deflation, as illustrated

by 1929 stock market crash and the experience of Japan. But

it does not follow that conventional monetary policy cannot

adequately deal with the threat of deflation by immediately

mopping up after the bubble collapse. Extra action may

actually exacerbate the problem under the circumstances that

inflation has already started out at a low level.

However, it is confident to say that the costs of recent

subprime crisis have turned out to be gigantic which some

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Nuwat Nookhwun

considered it the worst financial crisis of the century.10

The

housing bubbles, together with the integration of worldwide

financial system and the sophistication of financialinnovation, led to the worst financial and economic crisis.

Banks and financial institutions have exposed to such heavy

losses that mopping-up have turned out to be harder. This

severe fallout may indicate a larger potential gain if

attempting to prick the bubbles in the first place.

Policymakers will be much more aware of the threat of the

bubbles in this unceasingly developing world, especially when

there is signal of financial instability.

Actually, even authors that argue against monetary

policy targeting of asset prices has already acknowledged the

analytical channels that link asset bubbles to real and

financial variables including wealth effects and credit

constraint effects. A number of studies suggest that credit

booms and busts and asset price booms and busts can have

severe financial and economic consequences.11

Many of the

crises are preceded by asset bubbles and credit boom that

eventually became unsustainable.

10 See Kohn (2008). He totally changed his view from previous 2006

speech.

11 Cited from Roubini (2006)

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Agency Cost

Next, I would like to turn to interesting proactive

argument which concerns moral hazard problem. It is correct

to say that monetary policy needs to provide lender-of-last-

resort support to financial markets in the period of liquidity

seizure, following bursting bubbles. But, like any other form

of insurance, such lender-of-last resort liquidity support, while

allowing asset bubbles to grow without doing anything, may

lead to moral hazard distortions. As market participants

believe that central banks would bail them out when the

collapse occurs, they are encouraged to carelessly take risks.

So, in practice, it should have been accompanied by a

willingness to control the rise of bubbles when they do occur.

Critics would argue that an increase in interest rates thatresults in less availability of credit would itself increase the

adverse selection problem. To explain clearly, individuals and

firms with the riskiest investment projects are those who are

willing to pay the highest interest rates. If market interest

rates are driven up sufficiently, participants with good credit

risks are less likely to want to borrow. Only bad-credit or

risky borrowers are left in the market. Therefore, there is no

reason to think that in increase in interest rates would punish

the more spendthrift banks and borrowers for their supposed

lack of discipline during the bubble’s expansion.

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Nuwat Nookhwun

Kohn (2006) also debated that this moral hazard

argument is a misreading of history. U.S. monetary policy

has always been consistent with its mandate, which is tostabilize employment and inflation. The Great Moderation

12is

the most convincing evidence. In addition, critics can argue

that extra action may pose a more significant risk of moral

hazard. If a central bank takes extra action but speculative

activity continues unabated or even intensifies, how would

the strategy be? Do policymakers raise rates even further?

What are the consequences for the economy? Importantly,

one may perceive asset price targeting as another goal of

central banks.

Beyond those debates, there is an idea to find other

proper types of policy responses. Many economists believe

that the impact of bubbles has far more to do with financial

supervision and regulation. Bernanke (2002) has for a long

time believed that the FED should the right tool for the right

job. It should focus its monetary policy instruments on

achieving its macroeconomic goals while using its regulatory,

12 However, some blame “The Great Moderation” as the cause of the

latest crisis as it may have led many private agents to become less

prudent and to underestimate risks associated with their actions.

Monetary policy is subsequently blamed for contributing to the Great

Moderation. See Kohn (2008).

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Agency Cost

supervisory, lender-of-last-resort approaches to help ensure

financial stability. Specifically, the FED should ensure that

financial institutions and markets are well prepared for the

impacts of a large shock to asset prices. Banks should be

well capitalized and well diversified. The central banks can

also contribute to reducing the probability of boom and bust

cycles occurring in the first place, by supporting more-

transparent accounting and disclosure practices and working

to improve the competence of investors. During the crisis, the

central banks should provide ample liquidity until the

immediate crisis has passed. However, Cecchetti (2004) still

claims that until the efficacy of alternatives is proven, interest

rates are the only tool and the right response to emergingprice bubbles is to raise interest rates.

Considering again the monetary policy, though those

debates above suggest that in practice there are both

agreements and disagreements in conducting preemptive

monetary policy, however if focusing on the theoretical

literatures, many analytical models seem to support the role

of such policy13; some particularly support a non-linear one.

Bordo and Jeanne (2002A, B) interestingly concludes that the

13 See Roubini (2006) for other theoretical literatures supporting

preemptive policy. See also Posen (2006) for alternative views.

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Nuwat Nookhwun

optimal policy cannot be summarized by a simple policy rule

of the type so-called the Taylor rule. It depends on the

economic conditions in a complex, non-linear way. The levelof optimism is the factor that should be considered in making

policy decisions and there is a role for preemptive policy at

the intermediate level of optimism. Moreover, Gruen, Plumb,

and Stone (2005) shows that the optimal monetary policy

recommendations of the activist depend on the stochastic

properties of the bubble. The case for leaning against the

bubble bursting with monetary is stronger the lower the

probability of the bubble bursting of its own; the larger the

losses associated with bubbles, and the higher the impact of

monetary policy on the bubble process. Thus, this last

literature has given various conditions to decide whether to

implement a proactive policy. Note that all conditions are

almost related to the controversial debates above.

3. The Coincidence of Asset Price Bubbles and

Credit Boom

The debates above contribute to one important finding

that bubbles can do harm to the economy if there is financial

fragility. In this section, I further investigate this finding.

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Mishkin (2008) points out that some asset price bubbles can

have more significant economic effects, and thus raise

additional concerns for economic policymakers, by

contributing to financial instability. He interestingly reveals

the following typical chain of events.

“…Because of either exuberant expectations about

economic prospects or structural changes in financial markets,

a credit boom begins, increasing the demand for some assets

and thereby raising prices. The rise in asset values, in turn,

encourages further lending against these assets, increasing

demand, and hence their prices, even more. This feedback

loop can generate bubble, and the bubble can cause credit

standards to ease as lenders become less concerned about theability of the borrowers to repay loans and instead rely on

further appreciation of the asset to shield themselves from

losses. At some point, however, the bubble bursts. The

collapse in asset prices then leads to a reversal of the

feedback loop in which loans go sour, lenders cut back on

credit supply, the demand for the assets declines further, and

the prices drop even more. The resulting loan losses and

declines in asset prices erode the balance sheets at financial

institutions, further diminishing credit and investment across a

broad range of assets. The decline in lending depresses

business and household spending, which weakens economic

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Nuwat Nookhwun

activity. In the extreme, it can endanger the operation of the

financial system as a whole. …”

The above quotation illustrates the feedback loop whichhelps generate the coincidence of credit boom and asset

price appreciation that triggers financial instability and

fragility afterwards.14

Asset price bubbles and credit boom

could fulfill each other in their occurrence. Credit has role in

the forming of the bubbles through the flow of capital into

assets while bubbles, in turn, contribute to the credit boom

through collateral-constraint effect. Unfortunately, the

coincidence of both places a significant threat to the economy

when there are reversals.

The historical examples have also highlighted the role

of financial instability in determining the consequence of

asset price bust as well.15

The stock market boom of the

1920s was subject to easy credit and rising speculation.

There was speculative use of credit and when the market

collapsed, the banking system got into trouble. Turning to

Japan’s asset prices boom, there were an evidence that the

14 Trichet (2005), interestingly, views that it is possible that asset

price bubbles moderate the effects of financial market frictions, like

credit constraint, and improve the allocation of investment. But it

should not be at the expense of a stable financial system.

15 See Mishkin (2008) for full explanation of each crisis.

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Agency Cost

ratio of bank loans to gross domestic product surged and also

a financial deregulation which increases banks’ risk-taking

behavior. The subsequent decade after the bubble burst have

been termed the lost decade. Japan’s experience suggests the

importance of regulatory policies that prevent feedback loops

between asset price and credit provision. During the boom,

Japanese regulation that allowed banks to count as capital

unrealized gains from equities might have contributed to

banks’ appetite for equities during the run-up and to financial

instability when the market collapsed. The on-going

hamburger crisis, named after its origin, really confirms the

role of credit expansion during asset price bubbles. The

securitization process made ample liquidity available in manymarkets especially the bubbled subprime mortgage market.

The lenders began to ease standards as further appreciation in

house prices was expected. The process also linked the

unjustified mortgage market to worldwide financial market

through securitized product, for example the MBS and the

CDO, while investors of those products failed to investigate

risks. Once the subprime market collapsed, the financial

market was dragged down and eventually real economy falls

into recession.

In the statistical view, Trichet (2005) cites two

academic literatures on early warning signals which conclude

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Nuwat Nookhwun

an adverse role by both factors. One literature shows that

when both credit-to-income ratio and real aggregate asset

prices simultaneously deviate from their trends by 4percentage points and 40% respectively would have predicted

55% of financial crisis three years in advance.16

In another

paper, ECB staff found that broad money and credit

developments are among the few early indicators of high-cost

asset price boom periods. Bernanke (2002) also supports this

statistics by saying that during recent decades, unsustainable

increases in asset prices have been associated on occasions

with botched financial liberalization in both emerging and

industrialized countries. The liberalization was not matched

by increase in regulatory supervision and that resulted in a

rapid flow of credit into assets.

Given theoretical and empirical evidences above, the

fulfilling process of and the threat posed by such coincidence

are what central bankers should take into account. Therefore,

approach to regulation should favor policies that will help

prevent future feedback loops between asset price bubbles

and credit supply. Mishkin (2008) suggests interesting

16 Mishkin (2008) infers that credit condition can help identify

bubbles. When asset prices are rising rapidly at the same time that

credit is booming there may be greater likelihood that they are

bubbles.

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Agency Cost

examples. The rise in asset values that accompanied with a

boom must not result in higher capital buffers at financial

institutions, supporting further lending. Another one is that

capital requirements may be adjusted over the business

cycles. Moreover, regulation and prudential supervision must

address concerns about risk-taking behavior which are one of

major causes of the many crises.

Concerning monetary policy instruments, Disyatat

(2005) proposes targeting both, which he refers as the cause

of financial imbalances, explicitly in the central banks’ loss

function. He cited the main concern of the proactive view is

that the economy could be left to grow at an unsustainable

pace if monetary authorities do not respond to developingfinancial imbalances, and finally could have adverse

consequences for the goals of policy when they implode.

Thus, monetary policy should help lower the probability of a

disruption occurring in the first place. As a result, there must

be an explicit consideration for financial imbalances in the

loss function of the central bank, in addition to that of output

and inflation. The measure of financial imbalances adopted

by the authorities is assumed to be weighted average of asset

prices and household debt, the latter reflecting primarily bank

credit extension. Therefore, this literature moves another step

- 29 -



Nuwat Nookhwun

forward in letting central banks target both the bubbles and

the credit boom.

Before moving further to the theoretical model, I wouldlike to discuss the links between monetary policy, and credit

expansion and asset price. The model used in this paper

includes such links. Indeed, monetary policy can basically

affect, based on theory, both asset price and credit boom via

monetary transmission mechanism17

and can be a cause of

both asset price bubble and credit boom. The link to asset

price can easily be described by considering interest rate as

the opportunity cost of holding assets, thus lowering the

policy rate results in higher demand in asset market, and thus

asset prices.

In considering the effect to credit provision, asymmetric

information problem in the credit market is addressed. There

are two basic channels which the policy operates through.

The first one is the balance sheet channel which operates as

follow. Expansionary policy, which causes a rise in asset

prices, raises the net worth of firms and so leads to more

loans available because of the decrease in adverse selection

and moral hazards problems. The other one is the cash flow

channel. It tells us that expansionary policy causes an

17 See Mishkin (2007) for the transmission mechanism of monetary

policy.

- 30 -




Agency Cost

improvement in firms’ balance sheets because it raises cash

flow from interest payment. The rise in cash flow increases

the liquidity of the firm and thus makes it easier for lenders

to know whether the firm will be able to pay its bill. The

result is that adverse selection and moral hazard problems

become less severe, leading to an increase in lending.

4. The Theoretical Model

Let me remind you first that I attempt to find out

whether monetary policy should respond to asset price.

However, though the previous two sections mostly discuss

about the asset-price bubbles, this theoretical model is

regardless that asset price movement is a bubble or can be

warranted by fundamentals because it will be proven that

both types of movement can result in an inefficient

adjustment of the economy. The model here, as mentioned

previously, is a revised version of the model implemented by

Carlstrom and Fuerst (2001A). It is built upon Kiyotaki and

Moore’s model18

and describes the world under imperfect

18 Kiyotaki and Moore wrote the related paper in 1997. It is named

“Credit Cycles,” published in Journal of Political Economy.

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Nuwat Nookhwun

credit markets which firm’s borrowing is subject to its

financial position which can be represented by its collateral

or net worth. So, that collateral constraint will have an effecton the firm’s ability to borrow and thus its production.

Therefore, the model allows the effect from the collateral

shock that is resulted from the movement in asset price to

have an influence on the economy. That really captures the

real world’s situation which asset price shock usually

influents the economy through credit channel. Eventually,

welfare criterion will be used to judge the optimal policy.

The adaptation of the model involves the assumption

that the net worth is not the only factor determining the

firm’s borrowing. Indeed, the firm can borrow higher or

lower than its collateral depending on degree of agency cost.

Lower degree of agency cost implies that lenders are more

confident that their loans will be repaid. Thus, the collateral

constraint is more relaxed and that results in more funds

available to the firm. I will explain this thoroughly later. But

from the previous section, we may regard this degree of

agency cost as measure of credit boom and bust. In the

period of credit boom, the agency cost is low and that

enables the firm to borrow in a considerable amount. We

may also study additionally what role monetary policy should

- 32 -




Agency Cost

have on this variable. Moreover, the other important

adaptation of the model is that it can capture the effects

monetary policy has on both asset price and the degree of

agency cost (or credit condition). The previous section has

already described in details their transmission mechanisms.

There will be an implication from the credit channel of

monetary policy when we reach conclusions.

Now, I will start explaining the structure of the model.

This theoretical model consists of 2 representative economic

agents: households and entrepreneurs. I will discuss their

economic decisions thoroughly.

Households’ Behavior The households are the agents that distribute their labor

supply to entrepreneur’s production. The income received

from working is mainly used for their consumption and

saving. They live infinitely and their period-by-period utility

function is given by

( )

τ

τ

11

,

11

+−=

+t

t t t

LC LC U (1)

The utility function is built for simplicity when

analyzing their maximization behavior. The future utility is

discounted at rate . t C denotes the households’ consumption

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Nuwat Nookhwun

in term of consumption goods while t L denotes labor supply.

Their utility function implies that the households’ utility is

increasing with consumption and decreasing with laborsupply. Increase in labor causes the households less leisure

and thus reduce their utility, but they still have to work in

order to receive income in the form of real wage t w to pay

their consumption. So, in each period, they primarily have to

decide how much to consume and to work.

In addition, after consumption, households have to make

their saving decision. There are 2 means of saving. The first

mean is in the form of bond t B which pays gross interest rate

of t R next period. The other one is in the form of acquiring

shares to a real asset that pays out dividends of t D

consumption goods at the end of time-t. The exogenous

dividend process is given by

( ) D

t t DDt DDD11

1 ++ ++−= ε ρ ρ (2)

The process is an AR1, which next period’s dividend is

a weighted average of today’s dividend and the long-run

average of dividends (D ) plus a random i.i.d. shock ( Dt 1+ε ).

Such shock is so-called dividend shock or asset price shock

which is the important source of the movement in asset price

that I will find out its appropriate monetary policy response

later. Dρ can be considered as a lagged effect the present

dividend has on the future dividend. This coefficient must be

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Agency Cost

less than one so that the dividend converges to its long-run

average.

The asset trades at share price t q at the beginning of

the period. The asset price depends only on such dividend

process. It is increasing with the current and future dividend

levels, as theory suggests. Its price determination equation

will be found out later. Importantly, I assume that shares

must be purchased with cash accumulated in advance so that

the households have to face the cash-in-advance constraint.

( ) t t t t t t BM Dqf P −≤− (3)

t f is the amount of asset purchase while t M is the

money that is held in advance from the previous period to

buy asset. From the constraint above, assume further that thedividend is available within the period to acquire asset. The

explanation of the above equation is that the cash or money

held in advance, after purchasing bond, will be used to buy

asset. This constraint generates the effect the monetary policy

has on asset price as the households have to make a decision

on the types of saving which consists of asset and bond, and

the return on the latter is directly related to monetary policy.

We will also learn more about it later.

The other constraint facing households is the

intertemporal budget constraint which is given by

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Nuwat Nookhwun

( ) ( )t t t t t t t t t t t t t t t t Dqf P f qP RBLwP cP M M −−+−++−≤ −+ 111

(4)

t P is the price of the consumption goods. The

intertemporal budget constraint explains that revenue of the

households is generated from the money held in advance

from the previous period, labor income, bond revenue and the

asset acquired in the previous period. Note that the value of

the asset is determined by the present real price. Within the

period, the revenue of the households is used for

consumption, and saving in form of bond purchase and

acquiring asset. The money left is held in advance to the next

period to purchase asset.

To conclude, the households maximize their lifetime

utility subject to cash-in-advance and intertemporal budget

constraint. Thus, their optimization problem is such that,

( )( )

( ) ( )( )∑

∞

=

+−

+

−−−+−++−+

−−−+

+

−

=0

11

11

1

11t

t t t t t t t t t t t t t t t t t

t t t t t t t t

t

t

M Dqf Pf qPRBLwPcPM

Dqf PBM L

C

L

µ

λ

τ β

τ

(5)

- 36 -




Agency Cost

t µ and t λ both are lagrangian multiplier for each

constraint. To maximize their utility, they choose their

consumption, labor supply, bond and asset purchase, and

money held in advance to the next period.

The results of the first-order condition are shown below.

t C : ( ) 01 =− t t

t P µ β

1=t t P µ (6)

t L : 0

1

=

+− t t t t t wP L µ β τ

t t t t wP L µ τ =1

(7)

t B : ( )( ) 01 =−+−t t t

t Rµ λ β

t t t t Rµ µ λ =+ (8)

t f : ( ) ( )[ ] 0111

1 =+−−−− ++++

t t t

t

t t t t t t t t

t qP DqP DqP µ β µ λ β

( ) ( ) 111

1

++++

=−+ t t t

t

t t t t t

t

qP DqP µ β µ λ β (9)

1+t M : ( ) ( ) 011

1 =++− +++

t t

t t t µ λ β µ β

( ) ( )11

1

+++ +=

t t

t t t µ λ β µ β (10)

Substitute (6) in (7) yields

t t wL =τ

1

τ

t t wL =

(11)Substitute (6) and (8) in (9) yields

( )1+=− t t t t qDqR β

1++= t t t t t t qE RDRq β (12)

Substitute (6) and (8) in (10) yields

1

11

+

+=t

t

t P

R

P

β

11

1 =+

+

t

t t

t P

RP E β (13)

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Nuwat Nookhwun

From the outcomes of the households’ maximization

decision above, equation 11 shows that labor supply responds

positively to the real wage. Increase in the real wageencourages the households to supply more labor as it enables

them to generate more income for consumption.

Determination of the asset price is shown in equation 12. It

is the sum of the present dividend and the present value of

the expected asset price in the next period. Importantly, this

equation implies the link between the asset price and

monetary policy which suggests that movement in the interest

rate has a direct effect on real asset price. Because the

households have to hold money in advance to purchase asset,

the interest rate reflects the opportunity cost of such cash as

the cash can be used to purchase bond instead. Higher

interest rate contributes to higher opportunity cost and thus

lowers demand for asset and the asset price. This provides a

transmission channel in which monetary policy can have an

influence on asset price and eventually affect level of activity

when discussing entrepreneurs’ behavior. For equation 13, it

suggests that the Fisher equation is “off” a period.19

Entrepreneurs’ Behavior

19 Fisher equation explains that nominal interest rate must rise with

the expected inflation.

- 38 -




Agency Cost

Turning to the entrepreneurs’ behavior, they too are

infinitely lived and have linear preferences over consumption.

They hire labor supplied by households to operate a constant

return to scale production to produce consumption goods.

Their production function is given by

t t t H Ay = (14)

where t y is consumption goods produced, t A is the

current level of productivity and t H is the number of workers

employed at a real wage t w . Like dividends, the productivity

level is an exogenous AR1 random process given by

( ) A

t t AAt AAA11

1 ++ ++−= ε ρ ρ (15)

A

t 1+ε represents productivity shock, which is also of

interest in this study.In deciding how many workers to employ, the

entrepreneur is constrained by a borrowing limit, and in

particular, it must be able to cover the entire wage bill with

its loan. Carlstrom and Fuerst (2001A,B) consider “hold-up

problem” as a reason why the firm is constrained. The

problem supposes that the hired workers first supply their

labor input, but that output is subsequently produced if and

only if the entrepreneur provides his unique human capital to

the process. Therefore, the entrepreneur could force workers

to accept lower wages ex post, for otherwise nothing will be

produced. This problem can be entirely avoided if there is an

- 39 -



Nuwat Nookhwun

existing stock of collateral that the workers could simply

seize in such a case. Hence, to avoid this hold-up problem,

workers are willing to work if and only if the wage bill isentirely covered by existing collateral. Assume further that

there exist financial institutions that provide within-period

financing to the entrepreneur, and that this financing is used

by the firm to pay their workers. The financial intermediary

will concern about the hold-up problem, and thus limits its

lending to the firm’s net worth.

The other clarification of such constraint involves the

assumption of imperfect credit markets. Only the entrepreneur

knows the details of its proposed project. If outside investors

are to provide financing to the entrepreneur, they have no

way of knowing for sure what the firm will do with their

funds. Furthermore, investors may have limited ability to

punish the firm after the fact that it run off with their money,

or use the funds on a misguided production activity. In this

scenario, external investors will likely provide financing only

if they are sure they can recoup their investment if things

turn sour. That is to limit the size of their financing to firm’s

financial position which is the collateral that can be seized

after the fact.

From both reasons above, firm’s borrowing which is

used to finance the wage bill will primarily be constrained by

- 40 -




Agency Cost

its collateral or net worth. We will denote this collateral as t n

(net worth). The entrepreneur’s loan constraint is thus

t t t t nH w µ ≤ (16)

The constraint is partially in accordance with Carlstrom

and Fuerst (2001A,B). However, the modification of the

constraint appears that the entrepreneur can borrow higher or

lower than its collateral. The degree of agency cost reflects

the ratio which it can borrow with respect to its net worth.

We denote it as t µ but note that t µ is the reversed value of

such degree. Higher t µ or lower degree of agency cost implies

higher firm’s reliability that it will use its borrowing

efficiently and repay the debt, and thus higher amount of

funds from financial intermediary or external investors. Incontrast, lower t µ or higher degree of agency cost reflects

higher counterparty risk or default risk which reduces

financial institutions or outside investors’ incentive to lend.

Financial crisis, for example, may result in very very high

degree of agency cost. As already mentioned, this variable

can imply credit condition of the economy. A continually

high value of t µ (significantly more than one which enables

the firm to borrow more than its collateral) may represent a

period of credit boom. Meanwhile, the lower the value of t µ ,

the more difficult the financial institutions provide loans, and

that contributes to the credit bust.

- 41 -



Nuwat Nookhwun

For example, kohn (2008) suggests that after 2003,

borrowing constraints were being eased by new financial

developments, such as the growth of subprime lending andother nontraditional mortgages, fueled by investor demands

for higher yields on complex structured products. That would

result in higher t µ .

The process of the degree of agency cost is given by

( ) ( ) µ

µ µ ε α µ ρ µ ρ µ 111

1 +++ +−−+−= t t t sst RR

(17)

Degree of agency cost is also an exogenous AR1

random process. However, it is also determined by the gross

interest rate relative to its threshold. The interest rate is

positively affected to the degree of agency cost. As described

earlier in the previous section, this relationship represents the

credit channel of monetary policy which lower interest rate

results in the extension of loan by lowering agency cost. α

shows the effectiveness of such channel. The economies, that

have a close link between monetary policy and credit stance,

tend to have highα . That is, change in monetary policysignificantly affects credit provision. From the above

equation, too low interest rate for a long period of time can

result in continually high t µ which contributes to a long period

of credit boom. Lastly, the agency cost shock,µ ε 1+t , may be

resulted from financial deregulation, financial crisis, financial

- 42 -




Agency Cost

panic, changes in the expected economic outlook and many

more. Financial deregulation poses negative agency cost

shock and increases the value of t µ .

I will assume that the loan constraint binds so that labor

demand is given by

=

t

t t

t

w

nH

µ (18)

Decrease in the degree of agency cost and increase in

the net worth enable the entrepreneur to hire more labor as

the amount which it can borrow rises. Meanwhile, wage

increase lowers the number of workers hired because the

entrepreneur has to pay its wage bill with its constrained

loan.

Note that entrepreneur’s sole source of net worth is

previously acquired ownership of asset. Therefore, time-t net

worth is given by

t t t qen

1−= (19)

where t e is asset purchased by the entrepreneur. So, the

loan constraint now is given by

t t t t t qeH w 1−≤µ (20)

Importantly, the assumption that the loan constraint is

binding implies that the firm’s marginal profits per worker

employed is positive ( )0>− t t wA . The entrepreneur would like

to hire more workers because of its positive marginal profits

- 43 -



Nuwat Nookhwun

earned from hiring additional labor, but it cannot because the

collateral constraint limits its ability to do so. However, these

profits also motivate the entrepreneur to acquire more networth which enables it to employ more workers. Therefore, it

is a need to limit this accumulation tendency so that

collateral constraint remains relevant. The entrepreneur’s

budget constraint is given by

( )t t t t t t t t t

e

t wAH DeqeqeC −++=+ −1 (21)

The RHS of the equation show that the revenue of the

entrepreneur can be acquired from its profits from production,

the selling of the asset previously acquired, and the dividend

gathered from the asset purchased in that period. The

entrepreneur’s revenue is used for 2 transactions. The first

part is for consumption,e

t C , and the other for purchasing asset

which unlike the households, does not require any cash in

advance.

Using the binding loan constraint, we can rewrite this

constraint as

( )t t

t

t t t

t t t t t t

e

t wAw

qeDeqeqeC −++=+ −−

1

1µ

( ) ( )t

t t t t t t t t t t

e

t w

AqeqeDqeC 1

11

−− +−=−+

µ µ

(22)

Now, to prevent accumulation tendency from happening,

I will assume that the entrepreneur consumes its dividends

and fraction of its profits each period:

- 44 -




Agency Cost

( ) ( )

+−−+= −

−t

t t t t t t t t t

e

t w

AqeqeDeC 1

111

µ µ γ (23)

So that entrepreneur asset holdings evolve as

( )

+−= −

−t

t t t t t t

w

Aeee 1

11

µ µ γ (24)

where γ represents share of firm’s profit that is used to

purchase asset.

Equilibrium

After explaining the behavior of both economic agents,

market equilibrium is next to considered. There are two

markets in this theoretical model, the market for assets and

the labor market. The respective market-clearing conditions

are 1=+ t t f e20

and t t H L = . The equilibrium asset price is

given by 1++= t t t t t t qE RDRq β . As for labor market, equating

labor supply to labor demand and solving for the equilibrium

real wage and employment level yields

t

t t

t w

nw

µ τ =

( ) τ µ += 1

1

t t t nw

(25)

( ) τ

τ

µ += 1t t t nL (26)

The equilibrium real wage and employment level is

increasing with net worth and decreasing with the degree of

agency cost as net worth increase and agency cost decrease

20 The supply of asset is normalized to unity.

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Nuwat Nookhwun

make more loans available to the entrepreneur. So, it is able

to hire more workers. Subsequently, as labor demand

increases, the equilibrium wage rises as a result. Moreover, inthis model, the implied path for the inflation rate comes from

11

1 =+

+

t

t t

t P

RP E

β

Steady-state

We can use the above equations to solve for the steady-state of the model. Let π denote the steady-state inflation

rate wheret

t

P

P 11 +=+π . Then we have:

(27) 11

1 =+

+

t

t t

t P

RP E

β

β

π +=1

R

(28) 1++= t t t t t t qE RDRq β

β −=R

DRq

(29) ( )

+−= −

−t

t t t t t t

w

Aeee 1

11

µ µ γ

µ γ γ

γ µ

+−=1

Aw

(30) t t t qen

1−= and ( ) τ µ += 1

1

t t t nw

q

we µ

τ −

=

1

q

A

eµ

µ γ γ

γ µ τ −

+−

=

1

1

(31)τ

t t wL =τ

τ

µ

γ

µγ γ

γµ

−

+

=

+−=

11

1

1

AAL

- 46 -




Agency Cost

From equation (27) derived from the implied path for

inflation, the steady-state gross interest rate is increasing with

the steady-state inflation rate. This is in accordance with the

well-known Fisher equation that describes the relationship of

nominal interest rate and inflation. Equation (28) suggests

that the steady-state asset price is determined by the steady-

state gross interest rate and its steady-state dividend. Higher

dividend yields an increase in the steady-state asset price,

while higher interest rate lowers it as stated earlier that such

rate reflects opportunity cost of asset purchase. Therefore,

monetary policy does affect the share price at the steady

state. However, as the steady-state asset purchase is

negatively related with the steady-state share price asintroduced by equation (30), monetary policy will have no

effect on steady-state net worth. Note that net worth is

equivalent to the multiplication of asset purchase and its

price. As a result, it is also superneutral with respect to

steady-state employment and output.

The steady-state employment is determined by the

steady-state level of productivity and degree of agency cost.

Equation (31) tells us that the more the long-run average

productivity level, the more is the steady-state employment.

Concerning the degree of agency cost, lower steady-state

agency cost causes more steady-state employment because of

- 47 -



Nuwat Nookhwun

more loans available to the entrepreneur to employ workers.

Let me remind you again that t µ is the reversed value of the

degree of agency cost. High t µ

means low agency cost. It canbe inferred that economies that have lower agency cost, for

example developed countries, tend to have more steady-state

employment than less developed one.

Nevertheless, for any given economies, the imperfect

credit markets make the steady-state level of employment

“too low”. If there were no collateral constraint, then real

wage would be given by w = A, and employment byτ

t t AL = .

But these levels are not achievable because of such

constraint. Because 011

>−γ , 0

11

>−

µ

γ for any given values of µ .

So, the steady-state employment is kept lower thanτ

t A .

However, the most important finding from the employment is

that there is no unique optimal long run nominal rate of

interest.

Log-linearizing the modelBecause monetary policy has no effect on steady-states,

it is convenient to express the equilibrium in terms of log-

deviations and study the dynamic of the economy in the

short-run. Note that the ~ represents percent deviation from

the steady state.

- 48 -




Agency Cost

(32) ( ) τ

τ

µ += 1t t t nL

t t t nL ~

1

~

1

~

τ

τ µ

τ

τ

++

+=

(33) t t t qen 1−=

t t t qen ~~~

1 += −

(34) ( )

+−= −

−t

t t t t t t

w

Aeee 1

11

µ µ γ

( )( )

+−=

+

−

τ µ

µ µ γ

1

111

t t

t t

t t t

n

Aee

t t t t t nAee ~

1

1~~

1

~~1

τ

µ

τ

τ

+−+

++≈ −

Substitute (33) in (32) and (34) yields

(35) ( )qeL t t t ~~

1

~

1

~1+

++

+= −

τ

τ µ

τ

τ

(36) ( ) t t t t t t t t t t qAeqeAee ~

1

1~~

1

~

1

~~

1

1~~

1

~~111

τ µ

τ

τ

τ

τ

τ µ

τ

τ

+−+

++

+=+

+−+

++= −−−

(37) 1++= t t t t t t qE RDRq β

1

~~~~++

−=+ t t t t t q

RE D

R

RRq

β β

(38) ( ) ( ) µ

µ µ ε α µ ρ µ ρ µ 111

1 +++ +−−+−= t t t sst RR

µ µ ε

µ

α µ ρ µ

t t t t R

R ~~~~1

+−= −

In summary, the economy model consists of equations

(35)-(38).21 22

There is two predetermined variable, 1−t e and

1

~−t µ , and four exogenous shocks: t A , t D , t R and

µ ε t .

Equation (35) shows that change in employment is resulted

from change in degree of agency cost, asset acquired in the

21 The value of t e

~is approximated by implementing the mathematical

rule: ( ) ( )xx log1log ≈+±

22 The calculation of (37) and (38) involves total differentiation

approach.

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Nuwat Nookhwun

previous period, and asset price. Increase in those variables

all enhances firm’s borrowing. From equation (36), change in

asset purchase is determined by change in asset acquired inthe previous period, degree of agency cost, level of

productivity, and asset price. Positive changes in the first

three variables contribute to an increase in the present asset

purchase because they all raise firm’s profits which enables

the firm to acquire more asset. Increase in asset purchase in

the previous period and decrease agency cost raise the profits

by increasing firm’s ability to borrow and labor hired. On the

other hand, change in asset price poses adverse effect as its

positive change, though increases firm’s net worth and labor

demand, but also raises equilibrium wage subsequently. The

increase in wage, in turn, lowers firm’s employment and

profit.

Equation (37) explains movement in asset price, which

is negatively affected by change in gross interest rate but

positively related with change in the present dividend and

expected change in next period’s asset price. The explanation

is not different from what explains for the steady-state asset

price. Lastly, the change in the degree of agency cost is

determined by change in that degree in the previous period,

the gross interest rate, and its random shock. Expansionary

monetary policy (by lowering policy interest rate) results in

- 50 -




Agency Cost

lower degree of agency cost (or higher t µ ). The important

finding is that the effect of the same percentage change in

the monetary policy instrument rate differs across economies.

It depends onµ , the steady-state agency cost andα , the

measure of the linkage between monetary policy and credit

condition and the effectiveness of the credit channel of

monetary policy. The economies with high degree of agency

cost and/or an effective credit channel of the monetary policy

tend to have higher effect.

Next, before turning to the question of monetary policy,

it is useful to sharpen one’s economic intuition about the

model by considering several experiments. The experiments

are also useful in understanding the dynamics of the economyand optimal monetary policy decision.

5. Shock Experiments

Experiment 1: Shock to Productivity ( t A ) In order to

investigate such shock, assume there is no change in other

exogenous variables. Then we have

1

~

1

~−+

=t t eL

τ

τ

t t t Aee~~

1

~1 ++

= −τ

τ

By combining, we obtain

- 51 -



Nuwat Nookhwun

( )t t t ALL~~

1

~1 +

+=+

τ

τ (39)

Employment responds with a lag to shock to

productivity. Though the entrepreneur may want to employmore workers as a result of higher productivity level as it

can generate more profit from that, it cannot because the

employment is subject to the entrepreneur’s present net worth

which depends on previously-acquired asset. However,

increase in productivity can boost next period’s employment

as it increases firm’s output and profit, even if the number of

workers is unchanged. It enables the firm to purchase more

assets. Therefore, net worth is higher in the subsequent

period and that enables the entrepreneur to borrow more to

hire additional workers. Moreover, such effect is persistent.

Though the shock to productivity lasts only one period, the

effect on employment and thus on output lasts much longer

and only dies out at the rate given byτ

τ

+1. If the shock to

productivity is serially correlated, this effect remains, so that

the collateral constraint prolongs the effect of the productivity

shock.

- 52 -

Positive

Productivity

Shock

Output

and

profit

increase

Asset

purchase rises

Net worth

increases

Employment

improves

Constraint is

relaxed




Agency Cost

Experiment 2: Shock to Dividend ( t D ) Likewise,

assume that exogenous variables, except for dividend, remain

constant.

From 1

~~~~++

−

=+ t t t t t qR

E DR

RRq

β β , we have t

D

t DR

Rq

~~

−−

=β ρ

β

Then proceeding as before, we have

t

D

t t t t DR

ReqeL

~

1

~

1

~

1

~

1

~11

−−

++

+=

++

+= −−

β ρ

β

τ

τ

τ

τ

τ

τ

τ

τ

t

D

t t t t DR

Reqee

~

1

1~

1

~

1

1~

1

~11

−−

+−

+=

+−

+= −−

β ρ

β

τ τ

τ

τ τ

τ


( )D

t t t LL ε τ

τ ~~

1

~1+

+= − (40)

Despite the fact that employment does not respond

immediately to productivity level, it can respond to dividend

shocks contemporaneously. Once there is an innovation in

dividend, change in asset price occurs and thus net worth is

revised in the period shock takes place. Then the entrepreneur

could adjust its labor demand in accordance with its net

worth. The positive shock to dividend results in an increase

in employment as the collateral constraint is relaxed. Besides,

like productivity shock, the effect from shock to dividends is

also persistent.

- 53 -

Positive

Dividend Shock

Asset price

risesConstraint is

relaxedEmployment

improves

Output and

profit

increase

Asset purchase

rises

Net worth

increases



Nuwat Nookhwun

Experiment 3: Shock to degree of agency costs ( t µ )

For example, when there is financial panic, the collateral

constraint is more severe. The firm will be lent much lower

than usual. On the other hand, if financial deregulation takes

place, the entrepreneur will be provided with more loans in

hand given the same value of collateral. To investigate such

shock, also assume other exogenous variables remain stable.

Then we have

1~

1

~

1

~−+

++

=t t t eL

τ

τ µ

τ

τ

t t t ee µ τ

τ

τ

τ ~

1

~

1

~1 ++

+= −

µ µ ε µ ρ µ t t t

~~~1+= −


( )11

~

1

~~

1

~−− +

+++

= t t t t LLτ

τ ε µ ρ

τ

τ µ µ (41)

Like dividend shock, shock to degree of agency cost

affects employment contemporaneously because such shockalters firm’s ability to borrow and employment respectively.

Negative shock to degree of agency cost resulting in higher

t µ enhances firm’s borrowing in the period shock occurs and

finally, employment improves. These effects are persistent

through two channels. The first channel operates through the

- 54 -




Agency Cost

lagged effect of agency cost shock as the degree of agency

cost is serially correlated, thus it remains higher than its

steady state for some range of time, and benefiting firm’s

borrowing. Meanwhile, the other one involves continually

higher asset purchase resulted from increases in employment

and profit. Therefore, the effects are highly persistent. Lower

agency cost can result in a period of credit boom which

employment is benefited from that. On the other hand, the

positive agency cost shock, such as financial crisis, could

take times harming the economy before returning to a normal

situation.

Experiment 4: A monetary policy shock ( t R ) This

shock is generated from a change in central bank’s policy

interest rate.

- 55 -

Negative Agency

Cost Shock

Higher

Constraint is

relaxed

Output and

profit increase

Employment

improvesAsset

purchase risesp

is higher than

its steady state

for some range

of time.

Net worth

increases



Nuwat Nookhwun

From 1

~~~~++

−

=+ t t t t t qR

E DR

RRq

β β , we have t t Rq

~~ −= .

And Fromµ

µ ε µ

α µ ρ µ 111

~~~~+++

+−= t t t t RR

, we have t t t RR ~~~

1µ

α µ ρ µ µ −= −

.

Proceeding as before, we have

−

++

+−

+=

++

++

+= −−− t t t t t t t t R

RReqeL

~~

1

~

1

~

1

~

1

~

1

~

1

~111

µ

α µ ρ

τ

τ

τ

τ

τ

τ µ

τ

τ

τ

τ

τ

τ µ

−

+

+

+

+

+

=

+

+

+

−

+

= −−− t t t t t t t t R

RReqee

~~

1

~

1

1~

1

~

1

~

1

1~

1

~111

µ

α µ ρ

τ

τ

τ τ

τ µ

τ

τ

τ τ

τ µ


+

+−++

= −−− 111

~~1

~~

1

~t t t t t R

RRLL µ ρ

µ

α

τ

τ µ (42)

The effects from monetary policy shock are more

complicated than others. In summary, as suggested by

equation (42), there are both contemporaneous and laggedeffects.

- 56 -

Adver

se

Expansionary

Monetary Policy

Constraint is

relaxed.

Asset

purchase rises

Employment

improves

Agency cost

lowers

Asset price

rises

Output and profit

increase.i

is higher than

its steady

state for

some rangeof time.

f

Wage

increases

Employment

worsens

Output and profit

decrease

Asset

purchase falls




Agency Cost

The contemporaneous one is generated as follow.

Assume that central bank implements expansionary monetary

policy. Lower interest rate increases entrepreneur’s borrowing

by lowering the degree of agency cost and raising the asset

price. That helps boost the present employment. However, its

lagged effect tends to lower employment because as labor

demand increases, there is a rise in equilibrium wage which,

in turn, negatively affects the present employment. There will

be less profit and asset acquired which depresses future

employment.

Beyond the interest rate impacts, there is also a lagged

effect from change in the degree of agency cost. Since the

process of agency cost is serially correlated, expansionary

monetary policy that lowers agency cost in the decision-

making period will keep agency cost low in subsequent

periods before returning to its steady-state. So, low interest

- 57 -



Nuwat Nookhwun

rate can also trigger a credit boom and its effect on

employment will be highly persistent as well.

6. Optimal Monetary Policy

Now, we move to the most important part of this paper,

which is to find out the optimal monetary policy. As already

mentioned, the welfare criterion is method used to judge the

optimal policy. Here, the social welfare is the same as that

used in Carlstrom and Fuerst (2001A,B)

τ τ

τ τ

11

11

11

11

+−+=

+−+≡

++

t

t t t

t e

t t t

LDLA

LccV (43)

It is equivalent to the sum of the welfare of consumers

and entrepreneurs. Note that the entrepreneur has linear

preferences over consumption. The consumption by both

agents equals amount of output produced plus dividends

generated by asset. In this welfare function, labor is the only

factor to be chosen. In order to maximize the welfare of thesociety, we obtain the following first-order condition

τ

t t AL = (44)

Carlstrom and Fuerst (2001A,B) called the above

outcome “the first-best employment”. However, this first-best

employment is not achievable because there is collateral

- 58 -




Agency Cost

constraint in the world with imperfect credit markets. The

employmentτ

t t wL = is left too low because t t Aw < as a result of

such constraint. Importantly, it suggests that employment

should respond to productivity level, not to any other types

of shock. But, from the shock experiments above, the

contemporaneous employment does not respond to

productivity shock while responding to other types of shock.

Consequently, the collateral constraint causes the economy to

under respond to productivity shock, and over respond to

dividend and agency cost shocks. The economy really

responds inefficiently to shocks and that does not benefit the

social welfare.

Now we are interested if monetary policy can improveon this economy’s ability to respond to shocks. As we have

learnt from the steady state that there is no unique optimal

long-run interest rate, monetary policy may have a role in

stabilizing the economy in the short run. The appropriate

adjustment that is welfare-improving occurs when

t t AL~~τ = (45)

Imposing this on the economy model (35)-(38), we can

then back out the implied interest rate policy. This optimal

policy implies the following behavior:

( )qeA t t t ~~~

1

~

1++

+= −µ

τ

τ τ

( )qeA t t t ~~~

1

1~1++

+= −µ

τ (46)

- 59 -



Nuwat Nookhwun


( ) t t t t t t qqeee ~

1

1~~~

1

1~

1

~

1

~11

τ µ

τ µ

τ

τ

τ

τ

+−++

++

++

+= −−

t t t

ee µ ~~~1 += − (47)

The above equation implies that optimal policy must

keep t e~

equivalent to t t e µ ~~1 +−

From (36), we have

( ) t t t t t t qAee ~

1

1~~~

1

~~11

τ µ

τ

τ µ

+−++

+=+ −−

( ) ( )t t t t eAq µ τ ~~~1

~1+−+= − (48)


( ) ( ) ( ) ( )( )111

~~~1

~~~~~1 ++− +−++

−=++−+ t t t t t t t t t eA

RE D

R

RReA µ τ

β β µ τ

( ) ( )11

~~1

~~~~+− −

−

+−++

−

= t t t

A

t t t t R

E AR

ReD

R

RR µ

β β ρ τ µ

β

Substituteµ

µ ε µ

α µ ρ µ

t t t t R

R ~~~~1

+−= − in the above reaction

function yields

( )( ) ( )

−

−

+−+++

−

−+= +−− 111

~~1~~~~~

t t t

A

t t t t t

RE A

R

ReD

R

R

RR µ

β β ρ τ ε µ ρ

β

β α µ

µ µ µ

Further substituteµ

µ ε µ

α µ ρ µ 111

~~~~+++

+−= t t t t RR

yields

( )( ) ( )

( )

++

−−+

−

+−+

−

−−+=

+−

−

11

1

~~~

~

1

~~

~

t t t t

t

A

t t

t

RE R

R

AR

R

eDR

R

RR

µ

βεµρ

ββ

βτ

β

β ρβαµ

µ

µµ

µµ

(49)

- 60 -




Agency Cost

Assume that the discount factor and the autoregressive

coefficient are both low so that µ βρ β −−R is always positive.23

I also simplify the above reaction function by ignoring the

response to expected change in policy interest rate in the

future because such variable primarily responds to future

value of shocks which is likely to be small as they follow

AR1 process and some types of shocks are stabilized by the

present monetary policy. Moreover, the response to future

policy rate is further discounted by µ

βα , so it may be

insignificant that we could ignore.

From the policy reaction function above, equation (49),

there are some important findings concerning the optimal

monetary policy.First, when there is a positive shock to productivity t A ,

the central bank should lower the nominal interest rate so

that employment can expand in an efficient manner. A

constant interest rate policy does not allow this because of

the collateral constraint. This procyclical interest rate policy

overcomes the collateral constraint by making asset price and

the degree of agency cost procyclical, and thus allows the

economy to respond appropriately.

23 If it is negative, the policy response will be unjustified. For

example, the response to positive agency cost shock which depresses

the employment might be to raise the policy interest rate.

- 61 -



Nuwat Nookhwun

Second, and in contrast, if there is a positive shock to

dividend t D , the central bank should increase the interest rate

by enough to keep employment constant. It is inefficient foremployment to respond to this dividend shock, and the

central bank can ensure no response by raising the nominal

rate in response. In this case, the central bank increases the

nominal rate by enough to keep share prices lower.

Moreover, by responding in this way, the agency cost is

higher, which also helps lower the employment.

Third, in addition to productivity and dividend shocks,

the interest rate should also respond to shock to degree of

agency cost. If there is a negative shock which leads to

higher employment, the central bank should increase the

interest rate by enough to keep it constant. It is also

inefficient for employment to respond to agency cost shock.

However, the difference is that the interest rate in the

subsequent periods may also increase as well because there

are lagged effect transmitted through the future, but the size

of response for monetary policy will be discounted by µ ρ .

Therefore, continually higher interest rate may be needed.

However, if the interest rate rises by enough to keep agency

cost at its steady state, it will not generate any lagged effects

and thus the future interest rate movement is not needed. On

the other hand, if there is a positive shock to agency shock,

- 62 -




Agency Cost

for example, the financial crisis or panic, a continuously

lower interest rate policy should be implemented as it take

times for agency cost to return to its steady-state level.

Nevertheless, if the policy interest rate lowers by enough to

keep agency cost at the steady state level before the crisis or

panic occur, there will be no need for future course of policy

interest rate.

Fourth, there is an obvious danger to a policy with very

low average nominal interest rates or worse, near a zero

bound. The optimal policy requires an ability to move the

nominal rate adequately in response to shocks. As the

average nominal rate approaches the zero bound, this

flexibility is lost. In this model with collateral constraint, theFriedman rule

24would be detrimental as the central bank

loses all ability to respond in the way implied by (49).

Fifth, central bank may not always respond to shocks as

suggested by (49). We have learnt previously that the first-

best employment is not achievable because of the collateral

constraint. Thus, there is an incentive to allow shocks to

occur without monetary policy response if such shocks lead

24 Friedman Rule implies optimal monetary policy requires that the

central bank simply set the nominal rate of interest to zero

independent of asset prices or any other shocks that might buffet the

system.

- 63 -



Nuwat Nookhwun

to higher employment. Therefore, positive shock to asset

price and negative agency cost shock that enable the

entrepreneur to borrow more to finance further employmentcontribute to no monetary response at all until the first-best

employment is reached.

Sixth, the size of response to all shocks depends on the

effectiveness of the credit channel of the monetary policy,

which is represented byα . The reaction function above

suggests that the response by economies that have effective

credit channel of the policy or highα tend to be smaller than

the less effective ones. The intuition behind this finding is

that beyond its impact on asset price, the effect of the

interest rate can transmit effectively the credit channel of

monetary policy. Therefore, central bank does not need to

increase the interest rate by that much.

Lastly, the steady-state degree of agency cost can also

influence the size of response. We have learnt previously that

economies with low steady-state degree of agency cost (or

highµ ) tend to have low interest rate impact on credit

condition. Thus, they may need larger monetary policy

response to shocks. Meanwhile, economies with high agency

cost do not have to enormously adjust their interest rate in

response to shocks. Only a small-to-modest change in

- 64 -




Agency Cost

monetary policy can provide significant impact on credit

provision.

7. Conclusions

This paper addresses one of the most controversial

issues for monetary policymakers during the last decade. It

concerns the role of monetary policy in responding to asset

price and asset price bubbles. By adopting the adapted

version of Carlstrom and Fuerst (2001A) model, the results

show that there is a welfare-improving role for a monetary

policy that responds actively to asset price, productivity and

agency cost shocks. This activist interest rate policy allows

the economy to respond to shocks in an efficient manner.

Under the world with imperfect credit market, monetary

policy cannot eliminate the long-run impact of the collateral

constraint. The economy cannot achieve its first-best

employment. However, it can improve welfare by smoothing

the fluctuations in this constraint. When there are shocks to

asset price and agency cost, it is inefficient for employment,

induced by fluctuations in net worth or collateral, to respond

to such shocks. Therefore, monetary policy must respond to

keep it constant. Moreover, the size of the response also

- 65 -



Nuwat Nookhwun

depends on the effectiveness of the credit channel of the

monetary policy and the steady-state degree of agency cost.

Economies with effective credit channel and high agency costcould react smaller in response to shocks.

The result that suggests monetary policy has a welfare-

improving role when responding to asset price shock is in

line with many theoretical literatures which support proactive

policy. Though most literatures are likely to include the

central bank’s loss function in their model, this paper is

almost different by using kind of micro-foundation approach.

But, the results are alike. The interesting point from this

result is that monetary policy responds to shock or movement

in asset price regardless that it is bubble or can be justified

by fundamentals. Effects of an upward movement in asset

price must be stabilized by tightening monetary policy while

a fall in asset price which depresses employment by lowering

firm’s net worth must be accompanied by expansionary

policy. In the results from Bordo and Jeanne (2002A,B), the

central banks also do not care whether asset price rise is an

event of bubble or not when selecting the appropriate

monetary policy response to the possible asset price reversal.

They insisted such reversal can harm the economy no matter

how the boom is caused by. In this paper, asset price

- 66 -




Agency Cost

movement results in an inefficient dynamic of the economy

which monetary policy must act to stabilize.

In addition to asset price shock, shock to the degree of

agency cost requires monetary policy to respond counter-

cyclically as well. The model really proves the need to be

aware of agency cost shock because when shocks appear,

they can be highly persistent and contribute to a long period

of credit boom or contraction which inefficiently affects

employment and output. Therefore, the model can capture the

evidence in the real world where credit boom and bust can

trigger an unsustainable development of the economy.

Specifically, as discussed earlier, the credit boom, when

accompanied by asset price bubble, is a threat to theeconomy. They could generate a collateral-induced credit

crunch, financial crisis, and eventually economic slowdown

when reversals occur. Thus, it is important for monetary

authorities to be aware of such coincidence. In the context of

this theoretical model, both affect employment and output in

an inefficient manner. If they occur simultaneously,

aggressive monetary policy tightening may be required to

control them. However, when there are reversals which lead

to asset price bust and credit crunch, aggressive monetary

policy must be implemented.

- 67 -



Nuwat Nookhwun

The dependence of the size of the response on the

effectiveness of the credit channel of the monetary policy

also has an important implication. In the real world, theeffectiveness of the credit channel can alter in different

circumstances. In particular, when there is a financial crisis,

the credit channel seems to be ineffective. Credit extension

do not fully, or even marginally, respond to change in

monetary policy as financial risks and fragility keep financial

institutions reluctant to lend. As a result, in an absence of the

credit channel, a small-to-modest monetary expansion, say 25

to 50 basis point decrease in policy rate, during financial

crisis might be not enough to stimulate the economy.

Actually, it can be easily noticed that aggressive monetary

easing is used by most central banks to deal with the

aftermaths of subprime crisis. Many even continue lowering

their policy interest rate for many times. In order to measure

the effectiveness of the credit channel of the monetary policy,

explicit model of bank behavior is needed. The model would

tell us how banks or financial institutions make decision on

their amount of money lent. Other factors beyond net worth

of entrepreneurs would be considered.

However, though the model allows the coincidence of

credit boom and asset price bubbles, there is no interaction

between both of them. The possible extension of the model

- 68 -




Agency Cost

should include the feedback loop Mishkin (2008) explains.

Credit boom and asset price bubble support each other in

their occurrence and pose significant risks to financial market

when their reversals take place. The role of such feedback

loop could make this theoretical stylized model more realistic

and have some implications for monetary policymakers in

making policy decisions. My view here is that under the

model with such loophole, if the coincidence occurred,

monetary policy might respond to it less aggressively as

reduction in asset price would help depress collateral-induced

credit boom and credit contraction, in turn, helps lower

demand for asset.

Moreover, it would be interesting if the future studyconduct a numerical simulation of the parameters in this

model. That would enable us to know the exact size of

policy response to shocks. We can also study an appropriate

policy response to shocks under different economies or the

same economy but with different circumstances. Recall that

one term in the policy reaction function has been assumed to

be positive. Thus, the numerical simulation would contribute

to a deep investigation of such term and actually, it might

turn negative in some cases.

- 69 -



Nuwat Nookhwun

8. References

Assenmacher-Wesche, Katrin, and Stephen Gerlach (2008).

“Can monetary policy really be used to stabilize asset

prices?”, Vox EU, March 12.

Bernanke, Ben (2002). “Asset Price “Bubbles” and Monetary

Policy”, Remarks before the New York Chapter of the

National Association for Business Economics, New York,

October 15.

Bordo, Michael, and Olivier Jeanne (2002A). “Boom-Bust in

Asset Prices, Economic

Instability, and Monetary Policy”, NBER Working Paper

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Bordo, Michael, and Olivier Jeanne (2002B). “Monetary

Policy and Asset Prices: Does “BenignNeglect” Make Sense?”, Presented at the conference

“Stabilizing the Economy: Why and How”, held at the

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Agency Cost

Carlstrom, Charles T., and Timothy S. Fuerst (2001A).

“Monetary policy in a world without perfect capital markets”,

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Disyatat, Piti (2005). “Inflation targeting, asset prices and

financial imbalances: conceptualizing the debate”, BIS

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Revisited”, speech delivered at the Cato Institute’s 26th

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Agency Cost

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Nuwat Nookhwun, Monetary Policy and Asset Price under Timevarying Degree of Agency Cost

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