GDP at Risk: A Framework for Monetary Policy Responses to Asset Price Movements
25 Pages Posted: 14 Jul 2006
Date Written: March 2006
In analyzing the macroeconomic impact of asset price booms and crashes, it is the disasters that are the true concern. This suggests a different approach to risk; one based on examining the keeping the probability of output deviating from its trend (or price level deviations from its target trend) over some time horizon below some fixed threshold. Policy responses should be built in order to keep this "GDP at risk", or it analog "Price-level at risk", sufficiently small. In this paper I use data from a broad cross-section of countries to examine GDP at risk and pricelevel at risk arising from booms and crashes in equity and property markets. I show that the distribution of GDP and price-level deviations from their trends have fat tails, so the probability of extreme events is higher than implied by a normal distribution. Specifically, housing booms create outsized risks of output declines. This means that policymakers who are intent on averting catastrophes should react. The question is: How?
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