DP8804 | Monetary Policy Transmission in a Model with Animal Spirits and House Price Booms and Busts

Publication Date

01/01/2012

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Abstract

Can monetary policy trigger pronounced boom-bust cycles in house prices and create persistent business cycles? We address this question by building heuristics into an otherwise standard DSGE model. As a result, monetary policy sets off waves of optimism and pessimism ('animal spirits') that drive house prices, which, in turn, have strong repercussions on the business cycle. We compare our findings to a standard model with rational expectations by means of impulse responses. We suggest that a standard Taylor rule is not well-suited to maintain macroeconomic stability. Instead, an augmented rule that incorporates house prices is shown to be superior.