WORKI NG PAPER S ERI ES

NO. 364 / MAY 2004

ASSET PRICE
BOOMS AND
MONETARY POLICY
by Carsten Detken and
Frank Smets
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WORKI NG PAPER S ERI ES
NO. 364 / MAY 2004
ASSET PRICE
BOOMS AND
MONETARY POLICY
1
by Carsten Detken and
Frank Smets
2
1 The views expressed are solely our own and do not necessarily reflect those of the European Central Bank.We thank our
discussants Gerhard Illing and Peter Sellin and Kiel Week, 23-24 June 2003 conference participants and ECB Workshop, 11-12
December 2003 participants for valuable comments.We particularly thank Ramon Adalid for excellent research assistance.
2 European Central Bank. E-mail: Carsten.Detken@ecb.int and Frank.Smets@ecb.int.
This paper can be downloaded without charge from
http://www.ecb.int or from the Social Science Research Network
electronic library at http://ssrn.com/abstract_id=533122.
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ISSN 1561-0810 (print)
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CONT ENT S
Abstract 4
Non-technical summary 5
1 Introduction 7
2. Asset price booms and monetary policy: the
stylised facts 9
2.1 Methodology 9
2.2. Economic and financial developments
during asset price booms 11
2.3 Recessions and asset price collapses 15
2.4. Are the 1990s different from the 1970s
and 1980s? 22
3. The optimal policy response to asset price
booms and busts 23
3.1. Asset prices and the inflation/output gap
stabilisation trade-off 23
3.2 Asymmetric effects of asset price collapses
and monetary policy 27
3.3 The reactive approach and incentive effects 30
4. Conclusions 31
References 32
The Data 56
European Central Bank working paper series 59
Abstract
The paper aims at deriving some stylised facts for financial, real, and monetary policy developments
during asset price booms. We observe various macroeconomic variables in a pre-boom, boom and
post-boom phase. Not all booms lead to large output losses. We analyse the differences between high-
cost and low-cost booms. High-cost booms are clearly those in which real estate prices and investment
crash in the post-boom periods. In general it is difficult to distinguish a high-cost from a low-cost
boom at an early stage. However, high-cost booms seem to follow very rapid growth in the real money
and real credit stocks just before the boom and at the early stages of a boom. There is also evidence
that high-cost booms are associated with significantly looser monetary policy conditions over the
boom period, especially towards the late stage of a boom. We finally discuss the results with regard to
the theoretical literature.
JEL classification system: E44, E52, E58
Keywords: asset price booms, asset price bubbles, optimal monetary policy, over-investment, real
estate prices
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Non-technical summary

We characterise financial, real and monetary policy developments during asset price booms
aggregating information contained in 38 boom periods since the 1970s for 18 OECD countries. We
observe 26 variables in a pre-boom, boom and post-boom phase. An asset price boom is defined as a
positive deviation of an aggregate asset price indicator from its recursively estimated trend by at least
10 percent. The asset price indicator aggregates equity, private and commercial real estate prices
according to the respective weights in the economy. It turns out that both equity and real estate prices
rise strongly during the boom and crash in the post boom period. Real GDP growth is particularly
strong during the boom, which is mainly driven by total private investment and is also reflected in
housing investment, in both cases both in terms of growth rates as well as gaps (i.e. the deviation of
the ratio to GDP from trend). Monetary policy is looser during boom periods than in normal times as
is revealed by deviations from the Taylor rule, as well as money and credit conditions.
Not all asset price booms lead to a bust and not all busts to a financial crisis. Therefore we divide our
sample of boom episodes into high- and low-cost booms, depending on the relative post-boom growth
performance. This classification criterium thus focuses on the volatility of real GDP growth over the
whole boom and post-boom phase. We test which variables allow discriminating between high- and
low-cost booms. The clearest and most significant differences between high- and low-cost booms can
be found for the post-boom period. Real estate prices, and gaps, investment growth, housing
investment growth and gaps, just to name a few, drop significantly more in post-high-cost boom
periods. At the same time inflation gaps are significantly higher, monetary policy significantly looser
(as measured by deviations from a Taylor rule) and reductions in real money growth and gaps and real
credit growth and gaps significantly larger in post-high-cost boom periods.
There are fewer significant differences during boom periods. During high-cost booms, for example,
real estate prices rise stronger, the output gap improves more, real monetary and real credit growth is
larger and there is some evidence that monetary policy is loosened more. The stronger loosening of
monetary policy rather seems to be a passive monetary policy choice, as interest rates simply do not
rise sufficiently to neutralise the rising output and inflation gaps. A possible explanation is that
monetary policy authorities are uncertain about the cause of the asset price boom - productivity
induced or non-fundamental - and are therefore reluctant to act in a determined way. Another
explanation would be that towards late stages of the boom, central banks perceive to be trapped
between price stability and asset price (or rather investment-) stability and are reluctant to actively
trade-off one against the other. A third possibility is that the loosening of monetary policy with respect
to the Taylor rule towards the end of high-cost booms is a deliberate and desirable policy. It could be
that, depending on the stochastic properties of the asset price bubble, the optimal policy corresponds
exactly to the observed initial tightening and later relaxation of the monetary policy stance as the
boom proceeds. The loosening is supposed to be desirable due to lags in the transmission mechanism
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of monetary policy, so that a pre-emptive accommodation of the anticipated asset price crash becomes
optimal.
High cost booms also last on average one half to one year longer than low-cost booms and lead to an
about 3.5 percentage points larger deviation from the aggregate asset price trend. Unfortunately we
find only few significant differences in the pre-boom year, which would be most useful from a policy
makers perspective. What stands out is the higher real money growth in high-cost pre-boom periods
and higher real credit growth in the first year of booms. Neither of these two facts can be explained by
simple business cycle developments.
Our search for stylised facts with regard to asset price boom episodes, by construction, cannot say
much about the role of monetary policy in responding or even triggering asset price booms. Monetary
policy is clearly endogenous so that the issue of causality is not addressed. If anything, one would be
tempted to argue that low inflation is probably not related to high-cost booms, which instead rather
seem to be associated with too loose monetary policy.
We supplement the empirical analysis by a survey of the theoretical literature concerning optimal
monetary policy in times of asset price booms. To illustrate the difficulties involved in deriving clear-
cut conclusions, we finally present simulated optimal policy reactions to show how the monetary
policy response depends on the nature of the underlying shock responsible for the asset price increase.


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1. Introduction
Following a long bull market and the exuberance associated with the new economy boom of the
1990s, stock market indices have fallen sharply and persistently over the past two to three years.
Historically, asset price crashes have often been associated with sharp declines in economic activity
and financial instability. Large falls in asset prices can not only have substantial wealth effects on
consumption. They also reduce collateral values, which may lead to cuts in bank lending, thereby
exacerbating the fall in spending and leading to further knock-on effects on asset prices, lending and
economic activity. While since the start of the new millennium many industrial countries have
experienced economic slowdowns as stock prices have fallen. But these business cycle downturns
have not been particularly severe when put into (historical) perspective and the financial sector has
been quite resilient. One possible factor is that in many countries house prices have continued to rise.
Nevertheless, policy makers have come under pressure for not having responded earlier to the build-up
of the asset price boom, thereby possibly preventing or alleviating the subsequent bust and its effects
on economic activity and inflation.
1


In this paper we address a number of monetary policy issues associated with the occurrence of large
asset price booms and busts. The paper has two objectives. First, we want to characterise the real and
financial developments surrounding asset price booms. Following the recent work by Borio and Lowe
(2001), Helbling and Terrones (2003), Bordo and Jeanne (2002a, 2002b) and Mishkin and White
(2003), we identify asset price booms since the early 1970s and characterise what happens during the
boom, just before and immediately following it. We define asset price booms as a period in which
aggregate (i.e. weighted equity, commercial and private real estate) real asset prices are more than 10
percent above their recursively estimated Hodrick Prescott trend
2
. In light of the discussion above, our
focus is on the behaviour of monetary policy during those booms as captured by changes in short-term
interest rates, money and credit aggregates and deviations from Taylor rules. We make a distinction
between those booms that were followed by a large recession (high-cost booms) and those that were
not (low-cost booms) and compare the characteristic features including the monetary policy
response.

We find that the average length of aggregate asset price booms in the eighteen industrial countries we
study has increased from 1.3 years in the 1970s to 3.5 years in the 1980s and 4.4 years in the 1990s.
Their occurrence is, however, not uniform across countries. Asset price booms are typically associated
with a substantial increase in the output gap and the investment and housing investment/GDP ratio
relative to the respective trends. Moreover, these booms are supported by relatively easy monetary

1
See, for example, Greenspan (2002).
2
Our methodology is similar although not equal to Gourinchas et al. (2001) application to lending booms.
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conditions, as captured by low interest rates relative to a Taylor rule benchmark, and abundant
monetary and credit conditions as indicated by rising money and credit gaps as well as high money
and credit growth rates. In contrast, considering all booms, inflation rates do not move very much
during the boom, although inflation deviations from trend rise during the boom. The booms that were
followed by a large recession, and in some cases financial instability, are typically longer, give rise to
significantly greater real and monetary imbalances, and, in particular, are characterised by a big boom
and bust in real estate markets. High-cost booms are also characterised by a more positive inflation
gap, i.e. a larger deviation from the inflation trend, following the boom, in spite of the large drop in
output and investment.

Second, in light of this historical experience, we then review the theoretical literature on how central
banks should respond to such asset price booms. Should central banks have responded earlier to the
boom in order to reduce the size of the bust and its effects? Should central banks be more aggressive
in responding to the downward phase than they normally would have done? Four different strands of
the literature can be distinguished. The early work of Bernanke and Gertler (1999, 2001) and Cechetti
et al (2000) focused on whether it was useful to include a response to asset prices in addition to the
response to an inflation forecast. Dupor (2001, 2002a) analyses the trade-off that may arise between
price stability and asset price stabilisation when there are frictions in the credit market and non-
fundamental shocks in asset markets. Borio and Lowe (2002) and Bordo and Jeanne (2002b) focus on
the implications of the non-linearities that may arise as financial imbalances increase the probability of
a self-fulfilling bust in collateral values and credit, possibly leading to financial fragility. Finally, a
small number of papers have focused on the incentive and moral hasard effects that may arise when a
central bank responds too aggressively to an asset price collapse (e.g. Caballero and Krishnamurthy,
2003; Illing, 2001; Miller et al. 2000).

The literature review highlights that the optimal monetary policy response is not necessarily easy to
characterise. As shown in Smets (1997) and Dupor (2002b), the optimal response very much depends
on the underlying source of the asset price increase. In particular, the direction of the policy response
may be different depending on whether asset prices are driven by improved productivity or over-
optimistic expectations. Given the uncertainty surrounding estimates of equilibrium values of asset
prices, such an assessment of the sources of the shocks will in general not be an easy task. As
discussed in Dupor (2001) and illustrated in this paper with the model of Smets and Wouters (2003),
non-fundamental asset price shocks may introduce a trade off between inflation stabilisation and asset
price stabilisation. However, compared to cost-push shocks, the time inconsistency problem would
appear to be much less as such shocks will typically tend to move the output gap and inflation in the
same direction. A characterisation of optimal monetary policy becomes even more complicated when
one allows for the probability that a rise in financial imbalances may results in a financial crisis with
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large negative effects on economic activity and price stability. As shown in Bordo and Jeanne (2002b),
the optimality of a pre-emptive tightening of policy will then depend on a careful assessment of the
probability of a bubble emerging and an estimate of the costs of such pre-emptive action. Our
empirical results may be seen as consistent with recent findings that the build-up of large real,
financial and monetary imbalances may provide a good indicator of problems to come (e.g. Borio and
Lowe 2002). However, whether a more pre-emptive tightening than historically observed would have
been successful in preventing or alleviating the subsequent asset price collapse without imposing too
high a cost remains a question for research. Finally, we believe more research needs to be done on the
incentive and moral hazard effects of a reactive policy approach, whereby the central bank only
responds when the asset price collapse occurs. To the extent that such an approach provides implicit
insurance to the private agents against large asset price collapses, it may ex ante lead to larger run-up
in financial imbalances and increase the vulnerability of the private sector to asset market shocks.

2. Asset price booms and monetary policy: the stylised facts
In this section we describe the average development of financial, real and monetary policy indicators
around aggregate asset price boom episodes. In the following, we first lay out the methodology for
identifying asset price booms. Then we analyse how on average the economy evolved before, during
and following the asset price booms with a focus on monetary conditions. Finally, we distinguish
between those booms that were followed by a collapse in output growth and those that were not. We
attempt to identify the different characteristics between those two types of booms.

2.1 Methodology
In order to identify asset price booms we use the BIS data set on aggregate real asset prices. In this
data set an aggregate real asset price index is computed as a weighted average of real equity prices and
real residential and commercial real estate prices, where the weights are based on the relative share of
those assets in the private sectors wealth.
3
We define an asset price boom as a period in which the
aggregate real asset price index is continuously more than 10% above its trend.
4
The trend is
calculated recursively using a one-sided Hodrick-Prescott filter with a smoothing parameter of 1000.
5

Following Borio and Lowe (2002), we use the asset price gap rather than its growth rate to define a
boom. This allows to stress the concept of accumulated financial imbalances, e.g. reducing the weight
of periods of rapid asset price growth directly following an asset price collapse. It also allows for

3
For a description of how the aggregate real asset price index is constructed, see Borio, Kennedy and Prowse
(1994) and Borio and Lowe (2002).
4
Many thanks to Steve Arthur and Claudio Borio from the BIS for providing us their data set.
5
The lambda parameter is the same as in Gourinchas et al. (2001). See the data annex for a short discussion.
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sustained periods of asset price growth only slightly above trend to generate a boom as imbalances can
accumulate.
We are aware of the fact that the HP filter on average is too close to the data towards the sample end.
By choosing a of 1000 we let the trend only adjust very smoothly and introduce a phase shift of the
trend. The advantage is that the resulting boom periods start later than with a traditional trough to peak
method but earlier than a gap deviation from an ex-post trend (due to the phase shift). Our booms
could theoretically end after the peak, as long as the deviation from trend is still high enough but
would finish typically before a boom identified by an ex-post trend gap. This method in combination
with the threshold value of 10% gives very reasonable results, see figure A in the annex. Furthermore
it has the advantage that it can be computed in real time, i.e. as soon as data for the current year are
available. The recursive HP filter is similar to a moving average characterisation of the trend and is
thus resembling chartist methods used in financial market. This has the additional advantage that our
method might capture booms the way they were perceived at the time. Correcting the problems of the
HP filter at the current end by using forecasts (see e.g. Kaiser and Maravall, 1999) would be counter-
productive as first of all, it is exactly the phase shift that allows for a very reasonable timing of the
boom and second, good forecasts for asset prices are impossible to obtain with simple univariate
forecasting models (or in fact any other model).

Borio and Lowe (2002) have shown that deviations from trend (in particular applied to credit) are
relatively good predictors of financial instability. One consequence of our boom definition is that
different asset price booms can be of different length. In order to be able to compare financial and
economic developments in different asset price booms, we therefore calculate the average annual
growth rate during the boom as well as the change over the whole boom period. The pre-boom period
is defined as the two years before the asset price boom, while the post-boom period is defined as the
two years following the boom
6
.

Table A1 in the appendix lists each of the 38 aggregate asset price booms that we identify in this way.
Figure A in the appendix plots in the left graph the real aggregate asset price index, the recursively
estimated HP trend and indicates the asset price boom periods as shaded areas. It is also mentioned
whether the boom is classified as high (H) or low(L)-cost, as will be explained below. The right chart
repeats the real aggregate asset price index but also shows two of its three components, i.e. real

6
The length of the pre- and post-boom periods is arbitrary. It has been suggested to us to also let the length of
these periods be endogenously determined by some other threshold deviation from the trend. This would
certainly make sense, but entails the risk of very long pre- and post-boom periods, which could possibly overlap.
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residential property prices and real equity prices
7
. We find boom episodes in every country, although
they are not equally spread over each of the 18 countries considered. It is interesting to note that less
than five boom years each are found in the three largest countries of the euro area (Germany, France
and Italy) as well as in Belgium and Canada. In contrast 10 or more boom years spread over two or
three distinct periods are detected in Finland, Ireland, the Netherlands, and the United Kingdom. Over
the whole sample, the average length of the asset price booms is somewhat greater than three years.
This hides, however, a lot of variation across asset price booms. The longest successive boom period
identified in this data set lasts for nine years. It is the asset price boom in Finland from 1981 till 1989.
In addition, there are three additional successive boom periods lasting for 6 years or longer (Spain:
1986-1991; Ireland: 1995-2001; the Netherlands: 1994-2001). There is a tendency of the asset price
booms to become longer. The average length increases from 1.3 years in the 1970s to 3.5 years in the
1980s and 4.4 years in the 1990s. However, most of the boom episodes took place in the second half
of the 1980s and early 1990s (18 compared to 9 in the 1970s/early 1980s and 11 in the late 1990s/early
2000). In this context, it is worth noting that one factor which may have contributed to the larger
number of asset price booms in the 1980s is the financial deregulation that took place mostly around
that period.
While in a number of countries real estate prices and equity prices move very much in tandem (e.g.
United States, Sweden, United Kingdom), in other countries the correlation appears quite low (e.g.
Germany). This partly explains why in the late 1990s no aggregate asset price booms are detected in
the latter countries in spite of large equity price booms. Equity prices are typically much more volatile
than real estate prices. Another stylised fact is that real estate prices typically lag equity prices (Borio
and Lowe, 2002). Both features are a reflection of the fact that transaction costs in equity markets are
much lower than in real estate markets, so that real estate prices typically only respond sluggishly to
changing economic conditions.
8


2.2. Economic and financial developments during asset price booms
In order to characterise the typical behaviour of the economy around asset price booms, Table 1
computes summary statistics aggregating information across the boom episodes. Specifically, we
report the median (of all boom episodes) of average annual real growth rates over the period indicated
(i.e. the pre-boom period (2 years before the boom), the boom period (variable length: 1-9 years), the
post-boom period (the 2 years following the boom) and normal periods (excluding any of the

7
The third component, commercial real estate prices, has not been disclosed by the BIS due to confidentiality
agreements.
8
See, for example, Peersman and Smets (2003) who investigate the response of equity and real estate prices to a
monetary policy shock.
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periods mentioned before)
9
. All growth rates shown are real growth rates, i.e. deflated by consumer
price inflation. Furthermore we depict percentage deviations from trend growth rates or deviations
from trend of a variables ratio to GDP. This becomes important as some variables trend up or
downward over the whole sample period, which could bias the comparison between pre-, boom and
post-boom periods. In order to detrend the variables we choose three different approaches. The first
approach is using the ex-post HP filter over the whole sample period to derive the trend (=100). The
second approach uses the simple recursive HP filter as used for the boom identification (=1000). The
third approach corrects for the HP filters problems at the current sample end, by using 3 years of
ARIMA forecasts before computing the HP trend for the current date. The estimated ARIMA model is
identified separately for each variable and re-optimised each period according to the information
criteria programmed in TRAMO
10
.
As opposed to the choice of the detrending method with regard to the identification of the boom, the
issue of which method is to be preferred with respect to analysing behaviour around boom episodes is
not clear-cut. The ex-post detrending might be considered the cleanest way to correct for all structural
developments unrelated to the boom period, but in fact the ex-post trend using the standard considers
a lot of a variables longer swings as trend movement. Furthermore the whole future history
determines the gap from the trend at each point in time. The recursive methods have the advantage that
they can be used in real time. Only the recursive methods could thus be considered useful for policy
makers, who aim at discovering high-cost booms as soon as possible. The tramo-forecast procedure
corrects the phase shift, although only if the estimated ARIMA model has a decent forecast
performance, does the estimated gap gain in accuracy. In what follows below we will focus the
discussion on the results for the ex-post detrending method. But the tables in the annex show the
results for all three methods, which are used to check robustness of the findings.

The upper part of Table 1 shows that the median rise of real aggregate asset prices is 8.5 percent
during the boom while aggregate asset prices fall quite significantly in the two years following the
boom (on average -5.6 percent p.a.). The growth rate of aggregate asset prices is, however, already
high in the two years before the boom (on average 5.2 percent p.a.).
Our pre-boom years are anything else than normal years, which reflects the cumulative nature of the
boom definition. Equity prices rise already very strong just before the boom (by 9.1 percent p.a. in the
pre-boom period), while house prices mostly pick up during the boom (the median of average growth
per year during a boom is 7.8 percent). Tables A2a and A2b in the annex depict more details, both in

9
We decided to focus on medians instead of means due to the small sample and the high likelihood of outliers.
The same tables using means are available on request. There are no qualitative differences.
10
Tramo stands for Time series regression with Arima noise, missing observations and outliers. The software
is from V. Gomez and A. Maravall and is included in the Eviews 4.1 package.
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terms of variables and time periods considered. For example, Table A2a shows that equity prices are
already nearly flat in the last boom year while house prices still rise by 6.8%. Equity prices burst in the
first post-boom year while house prices fall more reluctantly in the first and stronger in the second
post-boom year.

Table 1: Overall financial and real developments during aggregate asset price booms: Medians





















Gaps are % deviations from ex-post trends. Rates of change are all in real terms. Av. stands for average. Pre depicts a
pre-boom period of two years, Post refers to the two years after the boom. LastB-Pre2 is the change between the last
year of the boom and the second year before the boom. Post2-Last is the change between the second year after the boom
and the last boom year. Normal shows the median of all other periods in the sample period 1970-2002.

This confirms the behaviour discussed above that equity prices usually lead house prices by one or two
years. The average drop in both equity and house prices is quite considerable in the two years
following the boom (8.0% and 3.2% respectively; see column Av. Post in Table 1).
The second panel of Table 1 describes developments in output and its components around asset price
booms. The behaviour of real GDP growth mirrors the behaviour of the asset prices: growth is high
during and immediately before the boom (close to 3.5 percent per annum) and drops to 1.3 percent
after the boom. The output gap, modelled as the log deviation from the ex-post trend, increases by 3.9
percentage points between the first pre-boom and the last boom year (the gap calculated with the other
two detrending methods show a slightly weaker increase of 2.8 and 1.7 percentage points, see Table
A2a). This reveals that the asset price boom is accompanied by a business cycle upturn. The rate of
change in real consumption is much less volatile. Contrary to investment growth, consumption growth
does not become negative in the two years following the boom. Furthermore, as Table A3a
11
in the
annex shows, consumption (rate of change and gaps) is the only real and financial variable, where

11
Table A3a further distinguishes between high and low cost booms as will be explained below.
Asset Prices:
agg. asset prices 5.2 8.5 -5.6 -0.5 3.9 -11.5
Agg. asset price gap -4.8 8.0 4.1 -3.8 19.6 -14.2
equity prices 9.1 12.8 -8.0 1.8 -0.8 -1.9
Equity price gap -5.0 13.6 -7.7 -9.7 26.7 -28.2
real estate prices 3.1 7.8 -3.2 -1.2 5.5 -10.7
Real estate price gap -5.3 4.5 7.3 -2.0 16.8 -8.9
Real Variables:
GDP 3.4 3.5 1.3 2.3 0.3 -2.4
Output gap -0.7 1.6 0.4 -0.5 3.9 -3.1
consumption 3.3 3.8 1.6 2.0 0.5 -1.9
Consumption/GDP gap -0.4 -0.5 0.9 0.1 0.4 1.3
investment 6.8 7.2 -3.2 2.1 -1.9 -9.1
Investment/GDP gap -1.7 4.2 2.0 -2.0 8.5 -10.2
housing investment 5.2 4.3 -5.3 0.1 -1.2 -4.8
Housing inv./GDP gap -1.6 4.4 0.1 -2.2 10.7 -8.3
Av. Pre Av. Boom Av. Post "Normal" LastB-Pre2 Post2-Last
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there is little significant change during the boom compared to the pre-boom period. This could suggest
that consumption smoothing is taking place, as consumers might realise that asset prices are not
necessarily going to last. The relatively moderate investment and housing investment gaps of around
4% during the boom hide a bit the strong rise between the first pre-boom and the last boom year of 8.5
and 10.7 percentage points, respectively. As a result there appears to be a considerable overhang in the
investment and housing investment ratio accumulating the longer the boom lasts. The drop in those
ratios two years following the boom is even more remarkable (-10.2 and 8.3 percentage points
respectively), suggesting an asymmetric behaviour of investment around asset price booms and busts.
This provides some back-up for the financial accelerator theories as discussed in Kocherlakota (2000).

Table 2: Overall monetary developments during aggregate asset price booms: Medians


















Gaps are % deviations from ex-post trends. Money and credit growth are real growth rates. A negative sign in the Taylor
gaps depicts to low an interest rate compared to the Taylor rule. Av. stands for average. Pre depicts a pre-boom period
of two years, Post refers to the two years after the boom. LastB-Pre2 is the change between the last year of the boom
and the second year before the boom. Post2-Last is the change between the second year after the boom and the last boom
year. Normal shows the median of all other periods in the sample period 1970-2002.

Table 2 describes the behaviour of monetary developments around boom episodes. Turning to the
behaviour of inflation and interest rates, one sees that inflation does not change much over the three
periods we focus on. It remains roughly constant between 4 and 5 percent. This level is though lower
than for the normal reference period (6%). This seems to confirm the observation by Borio and
Lowe (2002) that inflation by itself is not a very good indicator of financial imbalances. Tables A5a
and A5b reveal that everything mentioned so far with regard to booms over the whole sample period
1970-2002 is robust when the booms of the 90s are excluded. Still, the inflation gap rises slightly,
which illustrates the usefulness to also look at deviations from trend in cases where a clear slope of the
trend (here disinflation) would otherwise bias a systematic comparison of pre- and post-boom
developments. Table A3b in the annex shows that the rise of nominal and real interest rates (of 1.3 and
0.6 percentage points respectively, as depicted in Table 2) is not significant. But in terms of deviations
from trend nominal interest rates do rise significantly (by 2.5 percentage points). Interestingly the rise
Monetary Variables:
credit 4.5 7.1 1.2 3.6 2.1 -2.9
Credit/GDP gap -2.8 0.8 1.8 -0.6 5.9 -3.1
money 4.4 5.5 1.9 2.5 1.9 -1.3
Money/GDP gap -1.7 -0.6 0.3 -0.3 2.4 -1.2
Taylor gap 0.8 -0.4 -0.1 0.1 -2.2 2.2
F-Taylor gap (tramo) 0.4 -0.3 0.1 0.4 -1.3 0.3
CPI 4.5 4.0 5.2 6.0 0.8 -1.3
Inflation gap -0.9 0.1 1.1 -0.1 1.6 -0.6
Nominal interest rate 7.6 8.6 10.0 8.6 1.3 -0.8
Nom. int. rate gap -1.2 0.1 1.4 -0.4 2.5 -0.1
Real interest rate 3.7 3.7 4.8 2.4 0.6 -0.4
Real int.rate gap -0.2 0.3 0.5 -0.3 0.8 0.0
Av. Pre Av. Boom Av. Post "Normal" LastB-Pre2 Post2-Last
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in the real interest rate gap is not significant according to Table A3b. This is consistent with the Taylor
rule calculations
12
. The modest rise in nominal interest rates and the quasi constant real rates are not
enough to keep the monetary policy stance in line with the rising output gap. The monetary policy
stance loosens (on average over 5 different Taylor gap calculations, see previous footnote) by 2
percentage points over the whole boom period. In the last year of a boom, the mean of the 5 Taylor
gaps is 1.85 % (see Table A2b). The relatively loose monetary policy stance is confirmed by the
behaviour of money and credit aggregates around asset price booms. In line with the growth in asset
prices and economic activity, real credit and real money growth are quite strong before and during the
boom, and growth rates fall considerably in the two years following the boom. In order to measure the
degree of credit and money overhang we report the deviation of the credit/GDP ratio and the
money/GDP ratio from their respective trends (money and credit gaps). Between the last year of the
boom and two years before the boom the money gap widens by 2.4 percentage points while the credit
gap rises by 5.9 percentage points. Together with the evidence on interest rates, this suggests that
monetary conditions are on average relatively loose during asset price booms and are considerably
tightened in the post-boom phase.

2.3 Recessions and asset price collapses
Overall, the stylised facts described in Section 2.2 are consistent with a credit/collateral driven asset
price boom and bust cycle. In such a cycle loose monetary conditions contribute to high money and
credit growth, which stimulates spending, leads to an increase in asset prices and collateral values,
which in turn results in even looser financing conditions, higher lending, growth, etc. These
developments are then reversed when asset prices drop. The sharpness of the resulting contraction in
asset prices and economic activity suggests that the financial accelerator mechanism is indeed at work.
Consistent with observations by Borio, English and Filardo (2003), on average inflation does not
increase during the boom, suggesting that by itself it is a poor indicator of the asset price boom
reversal to come. In contrast, various, recursively estimated gap measures that attempt to estimate the
degree of real and financial imbalances, such as the money, credit and investment overhang, do
increase quite substantially during the boom. Of course, the evidence is only suggestive. In particular,

12
The Taylor benchmark is calculated using fixed coefficients of 0.5 on the deviation of inflation from the
inflation objective and on the output gap. The inflation objective, the equilibrium real interest rate and potential
output are all calculated using the Hodrick-Prescott filter in the very same three ways as mentioned before.
Furthermore we derive two forward-looking Taylor gaps, where next periods inflation and output are predicted
by a one-period ahead, optimised ARIMA forecast derived from TRAMO. The data annex shows the exact
equation how the Taylor gaps are derived.
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there has been no attempt to distinguish this story from one in which those patterns are the outcome of
underlying business cycle shocks.

In order to sharpen the picture somewhat, in this section we proceed as follows. We compare the asset
price booms that were followed by a sharp drop in real GDP growth rates (high-cost booms) with
those that were succeeded by a relatively mild slowdown in real growth (low-cost booms). We try to
find variables, which characterise high- and low-cost booms in pre-boom periods, during the boom as
well as shortly after the boom.
From a policy perspective, it is important to know what are the characteristics of asset price booms
that eventually are likely to result in a severe collapse in output. From an academic perspective, it is
important to see whether high-cost booms are characterised by features that suggest the working of a
collateral/balance sheet channel. High cost booms are those booms that were followed by a drop of
more than 3 percentage points in average real growth (comparing the three years following the boom
with the average growth during the boom), as long as the average post-boom growth is below 2.5%.
The cut-off point was chosen close to the average post-boom reduction in GDP (to divide the sample
of booms into two groups of sufficient size each). Eventually the chosen cut-off point of a growth
reduction of 3 percentage points is slightly higher than the average fall so that those asset price booms
of the 1980s that did not result in a banking crisis are classified as low-cost booms and vice versa.
13

Choosing the GDP drop cut-off point in this way was successful in achieving this aim. The only
exception is New Zealand 84-87, which we classify as low-cost, although it led to a banking crisis in
1987.
14
Table A1 in the appendix shows that there are 14 high-cost and 24 low-cost asset price
booms. The average length of the high-cost booms is 0.5 to 1 year longer (3.7) than that of the low-
cost booms (3.1). This suggests that the longer the asset price boom lasts, the more financial
imbalances build up and the more severe the following collapse.

Tables 3a and 3b compare the economic developments in high (H) and low-cost (L) asset price booms.
Table 3a focuses on developments for the average pre-boom, boom and post-boom periods as well as
the first two years of the boom separately. Table 3b depicts developments in the last year of the boom
as well as the medians of average changes between the average boom and pre-boom, the last year and
the second year before the boom period and the second year of the post-boom and the last year of the

13
The index of banking crises is taken from Bordo, Eichengreen, Klingebiel and Martinez-Peria (2001). The
banking crises included are Australia (1989), Denmark (1987), Finland (1991), Japan (1992), Norway (1987),
New Zealand (1987), Sweden (1991). There are also a number of episodes with banking problems identified in
Bordo et al (2001) which were not preceded by asset price booms as we have defined them: Germany (1977),
France (1994), United States (1984).
14
See data annex on New Zealand.
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boom periods. The column labelled ST stands for significance status with regard to the Wilcoxon-
Mann-Whitney test, testing for differences in populations between high- and low-cost booms.
15


Table 3a: Financial, real and monetary developments: Medians of high- (H) and low-cost (L)
booms (significance levels of Wilcoxon-Mann-Whitney test for differences between high- and
low-cost episodes)


















Stars (***, **, *) denote significance of the Wilcoxon-Mann-Whitney test, testing for the differences in populations between
high- and low-cost booms at the 5%, 10% and 15% level, respectively. For those variables where detrending has been used
significance levels of all three methods are reported.. Rev.means that a significant difference has been found for a
detrending method where the relative size of the medians is reversed compared to the ex-post method depicted in the table.
# The credit gaps (see Table A4c) for the simple recursive and the Tramo recursive trends both show a significantly larger
gap for high-cost booms at the 15% level .

Three (two, one) stars denote significance at the 5% (10%, 15%) level, respectively. For those
variables where detrending has been used, the significance status of all three detrending methods is
reported (ordered from most to least significant level). The figures reported always refer to the ex-post
detrending only. In case a significant difference is found for a detrending method where the relative
size of the medians is opposite to the one reported in the table for the ex-post trends, it is indicated by
a revfor reversed. The full results for the particular detrending methods and further time periods and

15
See annex for a description of the test.
H L ST H L ST H L ST H L ST H L ST
Asset Prices:
agg. asset prices 6.3 5.1 10.4 8.0 -9.1 -5.3 *** 8.8 10.0 12.1 3.6 ***
Agg. asset price gap -8.0 -4.3 10.4 6.9 *** * 5.1 1.5 -0.8 6.2 4.5 5.7 *** Rev
equity prices 12.7 8.1 11.2 13.7 -10.8 -6.6 14.9 25.1 16.9 -3.2 ***
Equity price gap -1.1 -5.5 * 15.7 11.2 -9.2 -5.4 * 11.4 16.8 14.6 7.1 *** **
real estate prices 0.7 3.8 9.3 6.2 *** -7.3 -1.3 *** 7.2 5.6 9.3 5.4 ***
Real estate price gap -12.1 -4.6 *** ** 6.8 3.2 * * 8.9 3.2 * * -2.7 1.5 3.2 1.6
Real Variables:
GDP 3.3 3.5 4.2 3.3 *** 0.1 1.6 *** 4.1 3.6 4.3 2.8 **
Output gap -2.0 -0.5 *** ** * 1.9 1.2 *** 0.6 0.2 0.4 0.9 1.4 1.4
consumption 3.2 3.5 4.1 3.3 *** -0.2 2.3 *** 3.7 3.3 5.0 3.1 ***
Consumption/GDP gap -0.7 -0.3 * * -0.5 -0.4 1.0 0.5 -1.1 -0.9 -0.1 -0.3
investment 6.1 7.2 7.6 6.3 -6.2 -2.2 *** 8.7 8.7 5.2 4.0
Investment/GDP gap -2.9 -1.6 ** 4.7 3.8 2.4 0.3 ** 0.1 4.3 ** 0.0 4.8 *** **
housing investment 2.7 5.7 4.7 3.5 -6.9 -0.1 *** 5.7 7.4 5.5 1.5
Housing inv./GDP gap -3.9 0.9 *** 6.7 2.3 -1.3 0.9 0.4 3.9 *** ** * 2.7 3.5 *
Monetary Variables:
credit 3.5 4.7 9.7 6.2 * -0.9 1.6 ** 8.4 4.0 ** 9.5 7.6 *
Credit/GDP gap -5.2 -1.8 *** 2.5 0.1 1.1 2.1 -0.1 -1.3 2.1 2.1 * * #
money 5.6 4.3 ** 8.5 5.0 *** 1.2 2.7 *** 7.4 5.3 9.3 3.7
Money/GDP gap -2.1 -1.2 -0.5 -0.6 * -0.3 0.3 -1.1 -0.6 -1.3 1.1
Taylor-gap 1.0 0.6 *** -0.3 -0.5 -1.3 0.4 ** 0.6 -0.6 0.5 0.0 *** ***
F-Taylor gap (tramo) 1.1 -0.8 *** ** -0.1 -0.7 0.3 0.1 0.9 -0.3 0.9 -0.8 ** **
CPI 6.2 2.9 * 6.5 3.0 5.2 4.2 6.3 3.3 * 5.2 2.3
Inflation gap -1.0 -0.6 0.0 0.1 1.3 0.4 * -0.6 0.2 -1.6 -0.2 *** *
Av. Pre Av. Boom Av. Post Boom1 Boom2
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variables are shown in the annex in Tables A4a-A4d for the whole sample 1970-2002 and in Tables
A6a-A6d for a sub-sample excluding the more recent booms of the mid 90s.

Concerning asset prices, it is clear that the average growth rate of real aggregate asset prices and real
equity prices during the boom is not significantly different in high-cost and in low-cost booms,
although the total increase is larger in high-cost booms because they last longer on average, as is
revealed by the significant difference in the average aggregate asset price gap during the boom. Real
estate prices during high cost booms grow faster than in low-cost booms (9.3% versus 6.2%), and
decline faster in the post-boom period (-7.3% versus 1.3%).

Table 3b: Financial, real and monetary developments: Medians of high- (H) and low-cost (L)
booms (significance levels of Wilcoxon-Mann-Whitney test for differences between high- and
low-cost episodes)



















Stars (***, **, *) denote significance of the Wilcoxon-Mann-Whitney test, testing for the differences in populations between
high- and low-cost booms at the 5%, 10% and 15% level, respectively. For those variables where detrending has been used
significance levels of all three methods are reported.. Rev.means that a significant difference has been found for a
detrending method where the relative size of the medians is reversed compared to the ex-post method depicted in the table.

The high cost of the asset price collapse appears in the first place to be associated with the
significantly greater collapse in house prices. Looking at Table 3b the most robust finding in the whole
paper is that the real estate price gap in high-cost booms is significantly higher in the last period of the
H L ST H L ST H L ST H L ST
Asset Prices:
agg. asset prices 9.0 4.1 4.1 2.3 3.9 3.9 -15.6 -7.8 **
Agg. asset price gap 17.5 9.8 *** *** 21.9 13.0 *** ** 28.7 18.3 *** *** -20.1 -13.3 *** **
equity prices 2.0 -3.2 -3.8 6.4 -7.1 1.1 -4.8 -0.5
Equity price gap 14.4 11.6 28.9 19.0 30.9 24.5 * -32.7 -27.5
real estate prices 9.8 5.4 * 8.5 3.1 *** 10.1 4.5 ** -16.3 -8.6 ***
Real estate price gap 18.8 7.1 *** *** *** 18.4 7.2 *** *** *** 30.0 11.8 *** *** *** -14.5 -4.7 *** *** ***
Real Variables:
GDP 4.1 3.1 1.0 -0.3 *** 1.1 -0.1 * -4.1 -1.3 ***
Output gap 3.9 1.7 *** * 3.5 1.5 *** ** ** 5.9 2.8 *** ** ** -5.5 -1.5 *** *** ***
consumption 3.8 3.0 1.4 0.6 0.6 0.5 -4.8 -1.3 ***
Consumption/GDP gap -0.4 0.2 0.6 0.0 1.0 0.4 1.3 1.0
investment 5.4 3.1 1.5 0.8 2.0 -3.1 ** -14.6 -6.3 ***
Investment/GDP gap 10.5 3.7 *** * 8.7 6.9 15.9 7.2 ** -12.3 -9.4 **
housing investment 4.2 1.0 * 1.5 -1.9 * 5.7 -4.6 *** -14.3 -2.0 ***
Housing inv./GDP gap 11.4 2.4 *** 9.4 5.1 16.0 6.3 *** ** ** -10.2 -1.9 ** ** *
Monetary Variables:
credit 6.7 6.2 4.1 0.4 * 1.8 2.2 -6.1 -1.9 ***
Credit/GDP gap 3.9 2.1 * 5.8 2.6 ** * 8.8 4.6 * * -4.6 -2.2 ***
money 6.2 3.1 ** 2.5 1.0 2.5 0.9 -5.2 0.6 ***
Money/GDP gap 2.6 0.2 *** *** * 1.6 1.7 * Rev 4.0 0.3 *** ** -2.0 0.9 *
Taylor-gap -2.3 -0.8 ** -1.4 -1.0 -3.0 -1.8 3.3 0.9
F-Taylor gap (tramo) -1.3 -1.4 -2.0 -0.4 ** * -3.3 -0.9 *** *** 1.2 0.2
CPI 7.1 3.6 * 0.4 0.6 1.1 0.7 -1.4 -1.0
Inflation gap 1.7 0.4 *** 1.0 0.8 2.1 1.5 -1.2 -0.5
Last Av.B-Av.Pre LastB-Pre2 Post2-Last
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boom (but not in the first or second year of the boom), and increases significantly more over the whole
boom period (30 p.p. compared to 11.8 p.p. rise) as well as it drops much stronger after the boom
(-14.5 p.p. versus 4.7 p.p.). Equity prices also drop more for high-cost booms in the post-boom
period but not significantly so. Tables A3a and A3b test for significant changes over time and confirm
the more dynamic development of aggregate asset prices during high-cost booms. For example only in
low-cost episodes is the real aggregate asset price growth rate in the last period of the boom lower than
in the first year of the boom. Only for high-cost booms is the asset price gap in the last period of the
boom in a robust way significantly higher than in the first period of the boom, which shows that the
dynamic development of asset prices is such that growth is persistently higher than trend growth all
over the boom period.

Turning to real developments, given our definition of high-cost booms, it is not surprising that the real
GDP growth rates during the high-cost asset price booms are greater than those in the low-cost booms
and smaller in the post-boom period. More interesting is the fact that only consumption growth is
significantly higher during a high-cost compared to a low-cost boom. Table A3a also shows that only
for high-cost booms does one find that consumption is significantly increased (at 15% level) during
the boom compared to the pre-boom period. This might suggest that there is less consumption
smoothing during high-cost booms, and that the asset price increase is perhaps partly, and wrongly,
considered to be permanent
16
. During low-cost episodes housing investment seems to be spread out
much more over time, as can be seen by the high housing investment growth already in the pre-boom
period. Actually, for low-cost booms housing investment is on average lower over the boom period
than in the pre-boom period. The opposite is the case for high-cost episodes. The differences in the
housing investment gap in the last period of the boom as well as the changes over the boom period and
after the boom are much more robust than for total investment, as is shown by table 3b. Only the
average post-boom period sees significant differences in consumption, investment and housing
investment growth. The reason for the few significant differences during the boom become clear when
analysing the time pattern of responses. There are few variables, which are useful to distinguish
between high- and low-cost booms in the real economy during the first two years of the boom.

Investment imbalances accumulate late in the boom, as can be seen by the large differences in the
investment and housing investment gaps in the last year of the boom, which is also confirmed when
looking at the changes between the last year and the first year of the pre-boom period (see column
LastB-Pre2 in Table 3b). The last column of Table 3b again confirms the many significant differences
with regard to the changes between the second year after the boom and the last year of the boom with

16
He fact that high-cost booms on average last longer might be part of the explanation as well.
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regard to consumption, investment and housing investment growth rates, as well as the housing
investment gap and (although less robust) the total investment gap.

Looking at monetary developments in Table 3a, it appears as if money and credit growth could be
useful to distinguish high- from low-cost booms, relatively early on. Real money growth is
significantly higher for the high-cost booms already during the pre-boom period. Both real credit
(9.7% vs 6.2%) and money growth (8.5% vs 5.0%) are significantly higher for high-cost than in low-
cost episodes during the boom. More importantly the differences for credit growth are significant for
each of the first two years of the boom (8.4% vs 4.0% in the first year of the boom). Inflation is
significantly higher in high-cost booms in the pre-boom period as well as in the first year of the boom,
but this pattern cannot be confirmed with evidence from inflation gaps. Actually the difference in
inflation is due to the fact that 10 out of 11 booms from the late 90s are low-cost booms, where
inflation has been very low. The difference in inflation rates vanishes if one looks at results for the 70s
and 80s booms alone (see Table A6c). Most importantly, the inflation gap for the whole sample is
significantly higher for high-cost booms in the last boom period and during the post-boom period. This
fact remains robust when the mid 90s booms are excluded (see Table A6d). Eye inspection of the time
pattern shows that there is an even steeper increase in the inflation gap for high-cost booms between
the second boom year and the first post-boom year. This is compatible with theoretically derived
stylised facts (see section 3), in which non-fundamental asset price booms, i.e. those not related to
productivity increases, will be accompanied by higher inflation. Furthermore, Table A3b shows that
the rising inflation gap during booms (i.e between the first year of the boom and the last year of the
boom) is more significant for high-cost booms. These observations are at least not incompatible with a
statement that price stability is positively related to financial stability. This seems to contradict the
claim by Borio and Lowe (2002, p.21) that a low inflation environment itself is one of the factors
conducive to costly boom/bust episodes. The combination of a smaller rise in the output gap and a
relatively more stable inflation may suggest that positive supply factors are more dominant behind the
asset price developments in low-cost booms.

According to the deviations from the Taylor rules
17
, Table 3a shows that if anything, monetary policy
is tighter during the high-cost pre-boom years and this remains so until at least the second boom year.
The longer the boom lasts the more significant becomes the difference in loosening the monetary
policy stance during high-cost booms as compared to low-cost booms. The policy stance is finally
significantly looser for the last year of the high-cost boom, according to the standard Taylor gap
calculation. Using the forward-looking Taylor rule we observe a -3 percentage points loosening in the
Taylor gap during the high- versus a -1 percentage point change during the low-cost boom (see

17
The deviation from the Taylor rule is measured as nominal interest rate minus the Taylor rule interest rate.
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column LastB-Pre2 in Table 3b). These differences are significant at the 5% level for both our
forward-looking rules, though not significant according to the three standard Taylor gaps.
18
Table A3b
strongly supports this argument by revealing that a significant loosening in time between the last and
the first year of the boom only occurs for high-cost booms. The loosening is significant for all 5
Taylor-gap measures for high-cost booms and not significant for any measure for the low-cost booms.
Looking at the nominal interest rate gaps in Table A3b also suggests that interest rates are increased
earlier in low-cost booms. Significant differences in the interest rate gaps compared to the second year
before the boom are already found for the first boom year for the simple recursive gap and for the
average boom years for all three gap measures for low-cost booms. Furthermore, credit and money
gaps rise more significantly over the high-cost boom periods (see LastB-Pre2 column in Table 3b).
Table A3b shows that the increase in the money gaps between the average boom period and the second
year before the boom is only significant for high-cost booms, not for low-cost booms. This again is
valid for all three gap measures. Table 3a also shows significantly larger reductions in credit and
money growth rates (with real credit growth actually becoming negative) for post-high-cost boom
periods. Overall there is some evidence that high-cost booms are associated with looser monetary
conditions towards the end of the booms, which could possibly have contributed in extending the
length of the booms.

One general objection to the interpretation of our tests is that significant differences might only reflect
differences in business cycle situations. We checked for this possibility by regressing each variable
(consisting of all 38 boom observations) on a constant and a dummy for high-cost booms while
correcting for heteroscedastic errors. We then tested the significance of the dummy variable by means
of a standard t-test. We then controlled for the business cycle situation by including the output gap
(here: HP-trend over the whole sample) and again tested the significance of the dummy variable. In
only 4 out of 60 tests did the qualitative result (i.e. significant or not at least at the 15% level) differ
between the two tests. Thus at this stage we are confident that the observed differences between high-
and low-cost booms are not only due to the fact that during high-cost episodes the business cycle
experiences a stronger upswing and a stronger decline following the high-cost boom. Still this issue
requires further research in order to identify a standard business cycle effect from a separate asset
price boom/bust effect possibly involving financial instability due to excessive leverage.

Overall, the picture is consistent with the stories that assign a large role to the interaction between
asset prices, collateral values, credit and economic activity (e.g. Kiyotaki and Moore, 1997). Those
asset price booms that lead to larger financial imbalances as captured by money and credit gaps and
larger asset price increases, contain the seeds of a subsequent collapse. As financial imbalances

18
These results are qualitativelt the same for the 70s/80s booms, but less significant (see Table A6d).
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increase, the risk of a collapse also increases. As real estate is the primary asset used for collateral, it is
mainly the rise and fall in real estate prices and the associated investment that contributes to the rise
and fall in output gaps. While the inflation gap does not respond much during the boom, there is a
difference between high- and low-cost booms in the last year and in the year following the boom. This
suggests that there would not necessarily have been a conflict between a more pronounced pre-
emptive tightening during high-cost booms and the maintenance of price stability over the medium
term. Although, simply reacting to inflation deviations from target in the current year or the
projections for the next year does not seem to be a winning strategy, which could avoid high-cost
booms to develop, as inflation gaps typically occur late in the boom. A broader based assessment of
monetary and financial stability seems to be advisable. The results give some support to the view that
credit and monetary growth rates together with a close eye on real estate price developments could be
used as indicators to detect a high-cost boom early on. The evidence presented, clearly supports the
view that distinguishing between high- and low-cost booms at an early stage in real time will certainly
remain a very difficult task and further research would be needed to advertise one or the other variable
as a suitable indicator. But looking at Tables A4a and A4c and in particular at the columns for the two
pre-boom years and the two first years of the boom, it seems that the real money and credit growth
rates seem to be the most promising candidate variables
19
. In particular, one of the few robust and
significant differences between high- and low-cost booms seems to be the higher average pre-boom
real money growth for high-cost episodes (see also Table 3a). The same is true for the higher real
credit growth in the first and second year of high-cost booms as compared to low-cost booms (8.4% vs
4.0% in the first year). One important aspect to stress is that neither of the latter two findings seem to
be pure business cycle phenomena. Significantly stronger GDP growth during high-cost episodes,
which could possibly itself trigger higher money and credit demand, can only be observed since the
second boom year, but not before. Differences in (real) real estate price changes, as well as real
consumption growth in the second boom year also seem to be suited in identifying high- versus low-
cost booms at a relatively early stage. In our view the stylised facts identified in this paper could form
a useful starting base to further explore the issue of early indicators.

2.4. Are the 1990s different from the 1970s and 1980s?
As discussed in Section 2.2, we identified eleven aggregate asset price booms in the mid to late
1990s/early 2000s. Ten of these booms are identified as low-cost booms. In order to classify the most
recent booms by comparing real GDP growth for three post-boom periods, we used OECD forecasts
for the years 2003 and 2004. Accordingly, only Finland 1997-2000 is a high-cost boom. One could

19
This is especially the case if one focuses on results which are robust for excluding the mid-90s booms, as
shown in Tables A6a and A6c.
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argue that due to macroeconomic convergence and financial market integration the 1990s were very
different from the previous booms and that it would not make sense to search for general patterns over
the whole sample period. Tables A6a-A6d in the annex show that most findings are robust when
comparing the whole sample with the results for the 1970s and 1980s only. The average length of the
asset price booms in the mid-90s is, however, considerably longer, as mentioned above. Regarding the
decomposition in equity and house prices, it appears that in the 1990s the strongest growth took place
in equity markets. One is tempted to argue that the 90s booms turned out to be relatively benign due to
the fact that real estate prices did not collapse (yet). Alternatively one could argue that as booms were
- so far - low-cost, real estate prices were not forced to decline, as a consequence of distress selling. In
our simple attempt to derive stylised facts, we cannot distinguish between these two interpretations.
The lower average inflation and nominal interest rates in the 90s caution against interpreting (not
detrended) results of these variables, which are not robust over the two sample periods.

3. The optimal policy response to asset price booms and busts
The previous section has shown that historically interest rates do not appear to have responded very
strongly to asset price booms. In this section, we review some of the academic literature on the
optimal response to asset prices in the light of these stylised facts. In the first subsection we discuss
the role of non-fundamental asset price shocks in creating a trade-off between inflation and output gap
and asset price stabilisation. This follows work by Dupor (2001, 2002). In the second section, we
discuss the implications of the asymmetric effects of an asset price collapse as highlighted by Kiyotaki
and Moore (1997) and Kocherlakota (2000). The implications of such asymmetric effects have been
examined in a simple three-period model by Bordo and Jeanne (2002).
20
Finally, in the last section we
briefly emphasise the moral hasard problems that may arise when central banks are perceived to
respond aggressively to an asset price collapse. As indicated by Miller et al (2000) and Illing (2001)
this may lead to a put option on asset prices and may exacerbate the development of financial
imbalances in the run-up.
3.1. Asset prices and the inflation/output gap stabilisation trade-off
A number of authors (e.g. Bernanke and Gertler, 1999, 2000; Cecchetti et al, 2001; Gilchrist and
Leahy, 2001) have examined to what extent central banks should respond to asset prices in addition to
their optimal response to an inflation forecast. Bernanke and Gertler (1999, 2000) and Gilchrist and
Leahy (2001) come to the conclusion that not much is to be gained from responding to asset prices in
addition to the implicit response that comes through the effect of asset prices on the inflation forecast.
In contrast, Cecchetti et al (2001) do find an additional positive effect on inflation and output gap

20
An early discussion can be found in Kent and Lowe (1997).
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stabilisation and relate this to the fact that asset prices may have implications for price stability at a
different horizon from that in a typical inflation forecast. The notion that the relevant policy horizon
may be different for asset price and credit market shocks is also acknowledged in recent speeches by
monetary policy makers (e.g. Issing, 2003; Bean, 2003).
21


Two additional remarks are worth making in this respect. First, as pointed out by Smets (1997), how
monetary policy makers respond to asset price movements with the aim of maintaining price stability
will very much depend on the source of the asset price movements. For example, when equity prices
rise because of a permanent rise in total factor productivity, then monetary policy may want to
accommodate the boom by keeping the real interest rate unchanged. In contrast, when equity prices
rise because of non-fundamental shocks in the equity market (e.g. over-optimistic expectations about
future productivity), then the optimal policy will be to respond by raising interest rates.

Secondly, as emphasised by Dupor (2001, 2002a), frictions in credit markets will generally create a
trade-off between stabilising inflation and stabilising asset prices. Stabilising inflation is optimal from
the perspective of reducing the misallocation of resources across various goods-producing sectors and
alleviating resulting distortions in the consumptionleisure trade-off. In the presence of non-
fundamental asset price shocks, stabilising asset prices is optimal because it reduces distortions on the
investment margin. However, with only one instrument, the short-term interest rate, the central bank
can not achieve both targets at the same time. Stabilising asset prices will lead to a rise in interest
rates, a fall in consumption, an increase in labour supply and a fall in inflation.

In order to illustrate both points, Figures 1 and 2 plot the impulse responses to respectively a
temporary positive productivity shock and a non-fundamental positive shock to equity prices in a
DSGE model with sticky prices and wages estimated on euro area data by Smets and Wouters (2003).
The estimated parameters are taken from Smets and Wouters (2003). In this model, investment is a
function of the value of capital (equity prices) due to the presence of investment adjustment costs.
Each figure plots three impulse responses corresponding to three alternative monetary policies. The
dotted lines correspond to the responses under the estimated reaction function, which takes the form of
a modified Taylor rule that includes the output gap and deviations of inflation from a target.
22
The
solid line corresponds to the responses under an optimal simple first-difference Taylor rule. The
optimised coefficients on the output gap is 0.15, while the one on inflation is 0.5. Finally, the line with
triangles corresponds to the optimal policy reaction when the central bank is able to commit. In the
latter cases, the loss function of the central bank is assumed to be a weighted average of deviations of

21
See also Brousseau and Detken (2001).
22
See Smets and Wouters (2003) for the parameter estimates.
25
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inflation from an inflation target and the output gap, defined as the difference between actual output
and the efficient flexible price level of output with equal weights.
Figures 1 and 2 show that in response to both shocks output, investment and equity prices rise.
However, the optimal monetary policy response is quite different in both cases. In the presence of a
positive productivity shock, both nominal and real interest rates fall (monetary policy is eased) in
order to avoid an output gap opening up. It is clear that the more aggressive easing under the optimal
policies succeeds in significantly closing the output gap and reducing the degree of disinflation.
Compared to the actual historically estimated monetary policy response, the optimal policy response
under the assumed loss function would boost equity prices. In contrast, the optimal response to a non-
fundamental shock to equity prices is quite different. In this case, both nominal and real interest rates
increase. Instead of a negative output gap, a positive output gap arises. Again, under the assumed loss
function the optimal policy under commitment is much more aggressive than the estimated reaction
function. The optimal policy succeeds in closing the incipient positive output gap by raising interest
rates aggressively and persistently. However, as pointed out by Dupor (2001), there is a cost in the
sense that the burden of adjustment falls mainly on consumption, and inflation actually falls under the
optimal policy. It is this trade-off which may make it costly to lean too aggressively against the non-
fundamental asset price boom and its stimulative effect on investment.

Finally, it is interesting to note that the simple first-difference Taylor rule is able to mimic the much
more complicated optimal reaction function under commitment. The differences are only minor.
This suggests that at least in this model without non-linearities or widely different lags in the various
transmission channels there is no need for an explicit response to asset prices. However, it is the case
that an increase in the variance of the equity price shocks will have an effect on the relative weight of
inflation and the output gap. Everything else equal a higher variance of equity price shocks will
increase the relative reaction coefficient to the output gap.

While non-fundamental equity price shocks may generally create an incentive to deviate from the sole
pursuit of price stability, there are a number of factors that should be taken into account before putting
this recommendation in practice. First, the central bank may not be able to commit to its future
policies. As in the presence of cost-push shocks, a conservative central banker who puts relatively
more weight on inflation stabilisation may in that case be able to obtain a better outcome. Second, in
the exercise pursued above, we have assumed that the central bank can perfectly distinguish between
both shocks in spite of the fact that they give rise to a similar positive response to output, investment
and equity prices. In practice, central banks have a difficult time distinguishing fundamental from non-
fundamental sources of asset price movements. Estimates of the equilibrium value of asset prices are
surrounded by a high degree of uncertainty. In such circumstances, the central bank will face a signal
extraction problem and may only gradually learn which shock has actually hit the economy. As in the
26
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Figure 1
Estimated and optimal response to a positive productivity shock
0 10 20
0
0.5
1
Output
0 10 20
0
0.5
1
Consumption
0 10 20
-1
0
1
2
Investment
0 10 20
-1
-0.5
0
0.5
Output gap
0 10 20
-1.5
-1
-0.5
0
0.5
Interest rate
0 10 20
-1
0
1
2
Equity prices
0 10 20
-0.3
-0.2
-0.1
0
0.1
Inflation
0 10 20
-1.5
-1
-0.5
0
0.5
Real rate
Est
Simp
Commit

Note: Impulse responses based on the DSGE model estimated on euro area data by Smets and Wouters (2003).

case of potential output uncertainty (e.g. Ehrmann and Smets, 2002), this may again limit the ability of
central banks to stabilise asset prices around the appropriate level and argue for a reduced weight on
asset price stabilisation.
23
The example studied in the section also abstracts from the fact that most
asset price bubbles build on good fundamentals. As was clear in the asset price booms of the late
1990s, the rise in equity prices due to positive productivity developments was amplified by over-
optimistic expectations which led to a further rise in asset prices, easier financing conditions and more
buoyant investment and economic activity. As shown by Jermann and Quadrini (2003), such optimism
may also lead to higher measured productivity growth as smaller, but high-growth firms find it easier
to enter the market.




23
Dupor (2002) analyses both the discretionary case and the case of imperfect information in a similar model to
the one used in this Section.
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Figure 2
Estimated and optimal response to a non-fundamental equity price shock
0 10 20
-0.2
0
0.2
0.4
0.6
Output
0 10 20
-0.6
-0.4
-0.2
0
0.2
Consumption
0 10 20
-1
0
1
2
3
Investment
0 10 20
-0.2
0
0.2
0.4
0.6
Output gap
0 10 20
0
0.1
0.2
0.3
0.4
Interest rate
0 10 20
-1
0
1
2
3
Equity prices
0 10 20
-0.1
-0.05
0
0.05
0.1
Inflation
0 10 20
0
0.1
0.2
0.3
0.4
Real rate
Est
Simp
Commit

Note: Impulse responses based on the DSGE model estimated on euro area data by Smets and Wouters (2003).

3.2 Asymmetric effects of asset price collapses and monetary policy
While a part of the literature on optimal monetary policy has focused on how to respond to
asset prices in linearised models, the more interesting question is how monetary policy should
deal with the possibility of a build-up of financial imbalances typical of asset price booms. Indeed, as
argued in Borio and Lowe (2000) and Borio, English and Filardo (2003) the question is not so much
whether central banks should prick asset price bubbles, but whether they should lean against the build-
up of financial imbalances which may later unwind at a much larger cost.

The basic mechanism of how asset price collapses may have disproportionate effects on lending and
economic activity when agents are highly leveraged is well understood and has recently been
formalised by Kiyotaki and Moore (1997) and Kocherlakota (2000) amongst others. The latter shows
that in the face of credit constraints that depend on the value of collateral, a shock to income may be
amplified, prolonged and have asymmetric effects in the sense that a negative shock has larger effects
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than a positive one. Such effects presumably also take place in the non-linearised version of the
financial accelerator model of Bernanke, Gertler and Gilchrist (2000). An alternative mechanism is
through the resulting fragility of the banking sector. Indeed many of the largest asset price booms and
busts observed in the 1980s have been accompanied by a banking crisis. In such cases, a rise in non-
performing loans leads to a contraction of the supply of bank lending which may in turn exacerbate the
economic crisis and lead to failures of banks, further increasing the fragility of the banking sector.

Bordo and Jeanne (2002) propose a stylised model to investigate the optimal response of monetary
policy to asset price booms when this risks leading to large collapses in lending and economic activity.
Bordo and Jeanne (2002) distinguish between two monetary policy approaches: a reactive and a pro-
active approach. Under the reactive approach, monetary authorities wait and see whether the asset
price collapse occurs and, if it does, respond accordingly. Under the pro-active approach, the monetary
authorities may attempt to contain the rise in asset prices and domestic credit in the boom phase in the
hope of mitigating the consequences of a bust, if it occurs. Central bankers appear to be divided
between both approaches. Defending his track record in the face of the recent collapse in stock prices,
Greenspan (2002) made a case for the first approach. He argued that, first, it would be very difficult to
identify a clear overvaluation of asset prices with the risk of a subsequent bust much in advance.
Second, when such risks are more clearly identified, policy action would often come too late and
would have to be so large that it would trigger the asset price bust. In contrast, Borio and Lowe (2002)
and Borio, English and Filardo (2003) have argued for a more pro-active and pre-emptive approach,
whereby central banks would pursue a tighter policy to reduce the build-up of debt and the associated
vulnerabilities, even if this implies lower inflation than would otherwise have been desirable.
24


In a stylised model in which the likelihood and the severity of a possible financial crisis depends on
the build-up of debt, Bordo and Jeanne (2002) find that the optimal monetary policy depends on the
economic conditions, including the private sectors beliefs, in a rather complex way. Basically, they
find that a proactive approach is optimal when the risk of a bust is large and the monetary authorities
can defuse it at a relatively low cost. However, they also find that there is tension between these two
conditions. As investors become more exuberant, the risks associated with a reversal in market
sentiment increase. At the same time, leaning against the wind of investors optimism requires more
radical and costly monetary actions. Overall, the various linkages between asset prices, financial
stability and monetary policy are complex because they are inherently non-linear and involve extreme
(tail probability) events. This implies that simple monetary policy rules may not be appropriate as a
guide for monetary policy in such circumstances. Instead, monetary authorities must take a stance on
the probability of such events and evaluate to what extent their actions may reduce this probability.

24
See also Crockett (2001).
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Recently Gruen, Plumb and Stone (2003) have argued that it is very difficult to derive the optimal
monetary policy when the bubble is building up, as long as the stochastic properties of the bubble are
unknown. Important determinants of whether the central bank should be tighter than according to a
standard Taylor rule depend negatively on the probability that the bubble will burst on its own accord,
and positively on the efficiency losses associated with bubbles and the strength of the impact of
monetary policy on the bubble process. Gruen, Plumb and Stone (2003) show that in many cases the
optimal policy is initially tighter and later in the bubble looser than a standard Taylor rule would
suggest. Surprisingly, this pattern is exactly the one we observe with our Taylor rule gaps for high-cost
booms. At this stage we would nevertheless refrain from considering this pattern of monetary policy
optimal in general, as the model, which derives this result, unrealistically considers the standard
interest rate transmission channel as the only channel by which monetary policy can affect liquidity in
a post-boom crisis.

As emphasised by Borio and Lowe (2002) and Borio, English and Filardo (2002), one crucial factor in
coming to such an assessment is whether during asset price booms financial and real imbalances are
building up. Central bankers are often sceptic about whether they are able to identify asset price
bubbles that may lead to sudden reversals and financial instability.
25
Large asset price booms may be
one indicator of the build-up of such imbalances, but as indicated in Section 2 above they are not
sufficient. However, those asset price booms that resulted in a costly subsequent adjustment usually
are accompanied by an increase in the money and credit overhang and a strong rise in real estate
investment and house prices. Indeed, Borio and Lowe (2002) find that a measure of credit overhang
works relatively well in predicting financial crises. As discussed in ECB (2003) and Issing (2002), the
evidence that money and credit indicators may, in certain circumstances, provide useful early
information for the development of financial instability, is one of the reasons for assigning a
prominent role to monetary analysis in the ECBs monetary policy strategy.

A second important factor is whether monetary policy actions will be able to affect the ex-ante build-
up of such imbalances without creating disinflation and a costly recession. Here the evidence that was
presented is less informative, because we may not have identified those episodes in which a strong
response of monetary policy may have prevented large asset price booms and a subsequent costly
collapse. However, the evidence of Section 2.3 did suggest that high-cost asset price booms were
characterised by a relatively loose monetary policy stance. This suggests that a more pre-emptive
policy tightening may have been appropriate. To assess whether it would have been successful to

25
See, for example, Greenspan (2002) and Goodfriend (1998). See also Bean (2003) for a discussion of the
recent experience at the Bank of England with how to respond to the rise in house prices.
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reduce the run-up of asset prices and debt and thereby to prevent or alleviate the subsequent collapse,
is beyond the scope of this paper.

3.3 The reactive approach and incentive effects
Finally, it is important to recall that the emergence of asset price booms and busts is partially
endogenous to the monetary policy regime. In the literature on how to respond to asset prices
discussed above, it is often forgotten that a strong response ex-post may have ex-ante consequences on
the likelihood and strength of the asset price boom and the build-up of financial imbalances. There are
a number of papers that have explicitly or implicitly addressed this issue. Miller et al (2001) discuss
the emergence of a so-called Greenspan put. They argue that the recent stock market bubbles could
have been less due to simple irrational exuberance but more due to an exaggerated faith in the share
price stabilising powers of the US Fed. Within the framework of Allen and Gales (2000) risk shifting
model Illing (2000) also assumes an asymmetric reaction function of the central bank in the sense that
it would supply liquidity in a crisis but be hesitant to withdraw it after the banking panic is
successfully avoided. Higher inflation is necessary to prevent the banking panic as inflation reduces
the real value of deposits. After a bad signal about the expected return of the risky asset has been
received, the central bank reduces the real value of deposits so that the latter equals the early
liquidation value of the risky asset, which obliterates the incentive for a bank run. It is shown how this
asymmetric behaviour of the central bank ex-ante creates a bubble in asset prices and thus increases
financial fragility, even without any of the standard ingredients like irrational exuberance, an agency
problem or uncertainty about the future supply of credit.
26


Bean (2002) builds a model in which firms need to decide how much to invest one period in advance
taking into account the probability that there may be a financial crisis which will lead to a loss in
productivity of their investment. The paper shows that under commitment the central bank may want
to act more agressively against inflation compared to a situation where there is no credit crunch
possible, because this will reduce its ex-post response in mitigating the effects of the financial crisis
and thereby lead to less over-investment ex ante by firms. Considering the possibility of a credit
crunch leads to less gradualist policy when moving from discretion to commitment. Expectations of
future output gaps are still useful in returning inflation to target, but do also encourage overinvestment
and thus increase the costs of a financial crisis.
27
Finally, in the context of a model of a currency crisis,

26
It should be noted that Illing (2000) argues that the asset price bubble created by moral hasard is small, so that
the optimal monetary policy would still be to stabilise the banking sector.
27
One should add that Bean himself noted that this result is unlikely to be robust as he assumed that a change in
todays interest rates has no direct effect on the level of borrowing in the economy.
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Caballero and Krishnamurthy (2002) discuss the optimal inflation targeting policy in a two-period
model. They show that given the possibility of sudden-stop events, in which foreign funds are not
anymore available to finance domestic investment, the optimal monetary policy would be
expansionary. It thus should not try to stabilise the exchange rate. The reason is incentive related. The
private sector would simply not take out sufficient insurance against exchange rate depreciations, in
case the central bank would be known to tighten monetary policy in times of exchange rate crises.

The pictures of the development of asset prices shown in the appendix give the idea of a clear boom
and bust pattern that is reminiscent of the typical stop and go policies of the 1960s and 1970s. Clearly,
the emergence of such boom-bust patterns will be endogenous to the monetary policy regime. One of
the important policy issues that need to be resolved is whether a monetary policy focused on price
stability will be sufficient to reduce the boom and bust features of asset markets seen in many
industrial countries.

4. Conclusions
We characterise financial, real and monetary policy developments during asset price booms
aggregating information contained in 38 boom periods since the 1970s for 18 OECD countries. We
observe 26 variables in a pre-boom, boom and post-boom phase. It turns out that both equity and real
estate prices rise strongly during the boom and crash in the post boom period. Real GDP growth is
particularly strong during the boom, which is mainly driven by total private investment and is also
reflected in housing investment, in both cases both in terms of growth rates as well as gaps (i.e.
deviations of the investment ratios to GDP from estimated stochastic trends). Monetary policy is
looser during boom periods than in normal times as is revealed by deviations from the Taylor rule, as
well as money and credit conditions.
Not all asset price booms lead to a bust and not all busts to a financial crisis. Therefore we divide our
sample of boom episodes into high- and low-cost booms, depending on the relative post-boom growth
performance. We test which variables allow to distinguish high- from low-cost booms. The clearest
and most significant differences between high- and low-cost booms can be found for the post-boom
period. Real estate prices, and gaps, investment growth, housing investment growth and gaps, just to
name a few, drop significantly more in post-high-cost boom periods. At the same time inflation gaps
are significantly higher, monetary policy significantly looser (as measured by deviations from a Taylor
rule) and reductions in real money growth and gaps and real credit growth and gaps significantly
larger in post-high-cost boom periods.
There are fewer significant differences during boom periods. During high-cost booms, for example,
real estate prices rise stronger, the output gap improves more, real monetary and real credit growth is
larger and there is some evidence that monetary policy is loosened more. The stronger loosening of
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monetary policy rather seems to be a passive monetary policy choice, as interest rates simply do not
rise sufficiently to neutralise the rising output and inflation gaps. A possible explanation is that
monetary policy authorities are uncertain about the cause of the asset price boom - productivity
induced or non-fundamental - and are therefore reluctant to act in a determined way. Another
explanation would be that towards late stages of the boom, central banks feel trapped between price
stability and asset price (or rather investment-) stability and are reluctant to actively trade-off one
against the other. A third possibility is that the loosening of monetary policy with respect to the Taylor
rule towards the end of high-cost booms is a deliberate and desirable policy. It could be that,
depending on the stochastic properties of the asset price bubble, the optimal policy corresponds
exactly to the observed initial tightening and later relaxation of the monetary policy stance as the
boom proceeds. The loosening is supposed to be desirable due to lags in the transmission mechanism
of monetary policy, so that a pre-emptive accommodation of the anticipated asset price crash becomes
optimal.
High cost booms also last on average one half to one year longer than low-cost booms and lead to an
about 3.5 percentage points larger deviation from the aggregate asset price trend. Unfortunately we
find only few significant differences in the pre-boom year, which would be most useful from a policy
makers perspective. What stands out is the higher real money growth in high-cost pre-boom periods
and higher real credit growth in the first year of booms. Neither of these two facts can be explained by
simple business cycle developments.
Our search for stylised facts with regard to asset price boom episodes, by construction, cannot say
much about the role of monetary policy in responding or even triggering asset price booms. Monetary
policy is clearly endogenous so that the issue of causality is not addressed. If anything, one would be
tempted to argue that low inflation is probably not related to high-cost booms, which instead rather
seem to be associated with too loose monetary policy.
We supplement the empirical analysis by a survey of the theoretical literature concerning optimal
monetary policy in times of asset price booms. To illustrate the difficulties involved in deriving clear-
cut conclusions, we finally present simulated optimal policy reactions to show how the monetary
policy response depends on the nature of the underlying shock responsible for the asset price increase.

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Table A1
Aggregate asset price booms in selected industrial countries (1970-2002)
High-cost Low-cost Boom years
Australia* 85-89 80-81 7
Belgium 89-90 2
Canada 88-89 2
Switzerland 73 86-89 5
Germany 90 1
Denmark 84-86 73; 97-01 9
Spain 86-91 00-01 9
Finland 81-89; 97-00 13
France 89-90; 00-01 4
Ireland 78-79; 87-90; 95-01 13
Italy 81; 90-91 3
Japan 73; 86-90 6
Netherlands 77; 89-90; 94-01 11
New Zealand 84-87; 95-97 7
Norway 84-87 73; 97-00 9
Sweden 87-90 96-00 9
United Kingdom 72-73; 85-89 98-00 10
United States 86-87; 96-00 7
Number of booms 14 24
Number of boom years 52 75 127
Average length of boom 3.7 3.1
*Australia is the only country for which we identified 2002 as a boom year. As we do not know how long the
boom will last, we excluded this boom from all calculations.
36
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
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M
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37
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
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M
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38
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
























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39
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
























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40
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
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3


41
ECB
Wor ki ng Paper Ser i es No. 364
May 2004





















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B
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5


43
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
























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44
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Wor ki ng Paper Ser i es No. 364
May 2004
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45
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Wor ki ng Paper Ser i es No. 364
May 2004
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46
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
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P
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47
ECB
Wor ki ng Paper Ser i es No. 364
May 2004



















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Wor ki ng Paper Ser i es No. 364
May 2004
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49
ECB
Wor ki ng Paper Ser i es No. 364
May 2004















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2
50
ECB
Wor ki ng Paper Ser i es No. 364
May 2004

Figure A
Australia










Belgium










C
Canada
1. Canada







4.4
4.5
4.6
4.7
4.8
4.9
5.0
5.1
5.2
1970 1975 1980 1985 1990 1995 2000
Aggregate Trend
H L
4.2
4.4
4.6
4.8
5.0
5.2
5.4
1970 1975 1980 1985 1990 1995 2000
Aggregate Equity Real estate
4.0
4.4
4.8
5.2
5.6
6.0
1970 1975 1980 1985 1990 1995 2000
4.5
4.6
4.7
4.8
4.9
5.0
5.1
5.2
5.3
1970 1975 1980 1985 1990 1995 2000
L
4.5
4.6
4.7
4.8
4.9
5.0
1970 1975 1980 1985 1990 1995 2000
H
4.2
4.4
4.6
4.8
5.0
5.2
5.4
5.6
1970 1975 1980 1985 1990 1995 2000
51
ECB
Wor ki ng Paper Ser i es No. 364
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48

Switzerland











Germany











Denmark








4.4
4.5
4.6
4.7
4.8
4.9
1970 1975 1980 1985 1990 1995 2000
Aggregate Trend
H L
4.0
4.4
4.8
5.2
5.6
6.0
6.4
1970 1975 1980 1985 1990 1995 2000
Aggregate Equity Real estate
4.5
4.6
4.7
4.8
4.9
1970 1975 1980 1985 1990 1995 2000
H
3.6
4.0
4.4
4.8
5.2
5.6
6.0
1970 1975 1980 1985 1990 1995 2000
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
5.0
5.1
1970 1975 1980 1985 1990 1995 2000
H
L
L
3.2
3.6
4.0
4.4
4.8
5.2
5.6
6.0
1970 1975 1980 1985 1990 1995 2000
52
ECB
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May 2004
49

Spain











Finland










France








4.4
4.6
4.8
5.0
5.2
5.4
5.6
1970 1975 1980 1985 1990 1995 2000
Aggregate Trend
H
L
4.0
4.5
5.0
5.5
6.0
6.5
7.0
1970 1975 1980 1985 1990 1995 2000
Aggregate Equity Real estate
4.0
4.2
4.4
4.6
4.8
5.0
5.2
5.4
5.6
1970 1975 1980 1985 1990 1995 2000
H H
3.5
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
1970 1975 1980 1985 1990 1995 2000
4.5
4.6
4.7
4.8
4.9
5.0
5.1
1970 1975 1980 1985 1990 1995 2000
L
L
4.0
4.4
4.8
5.2
5.6
6.0
6.4
1970 1975 1980 1985 1990 1995 2000
53
ECB
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May 2004
50
Ireland











Italy











Japan






4.0
4.4
4.8
5.2
5.6
6.0
6.4
6.8
1970 1975 1980 1985 1990 1995 2000
Aggregate Equity Real estate
4.4
4.6
4.8
5.0
5.2
5.4
5.6
5.8
6.0
1970 1975 1980 1985 1990 1995 2000
Aggregate Trend
L
L L
4.4
4.5
4.6
4.7
4.8
4.9
5.0
5.1
1970 1975 1980 1985 1990 1995 2000
L
L
3.6
4.0
4.4
4.8
5.2
5.6
6.0
1970 1975 1980 1985 1990 1995 2000
3.6
4.0
4.4
4.8
5.2
5.6
1970 1975 1980 1985 1990 1995 2000
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
5.0
5.1
1970 1975 1980 1985 1990 1995 2000
H
H
54
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
51
Netherlands
2.
3.
4.
5.
6.
New Zealand
7.
8.
9.
10.
11.
Norway
12.
13.
14.
15.
16.

3.8
4.0
4.2
4.4
4.6
4.8
5.0
5.2
5.4
1970 1975 1980 1985 1990 1995 2000
3.8
4.0
4.2
4.4
4.6
4.8
5.0
5.2
1970 1975 1980 1985 1990 1995 2000
4.4
4.6
4.8
5.0
5.2
5.4
5.6
1970 1975 1980 1985 1990 1995 2000
Aggregate Trend
L L L
3.5
4.0
4.5
5.0
5.5
6.0
6.5
1970 1975 1980 1985 1990 1995 2000
Aggregate Equity Real estate
4.3
4.4
4.5
4.6
4.7
4.8
4.9
5.0
1970 1975 1980 1985 1990 1995 2000
L L
4.0
4.2
4.4
4.6
4.8
5.0
5.2
1970 1975 1980 1985 1990 1995 2000
H
L
L
55
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
52
Sweden












United Kingdom











United States









4.0
4.4
4.8
5.2
5.6
6.0
6.4
1970 1975 1980 1985 1990 1995 2000
4.0
4.4
4.8
5.2
5.6
6.0
1970 1975 1980 1985 1990 1995 2000
3.6
4.0
4.4
4.8
5.2
5.6
6.0
6.4
6.8
1970 1975 1980 1985 1990 1995 2000
Aggregate Equity Real estate
4.4
4.6
4.8
5.0
5.2
5.4
5.6
5.8
1970 1975 1980 1985 1990 1995 2000
Aggregate Trend
H L
4.2
4.4
4.6
4.8
5.0
5.2
5.4
1970 1975 1980 1985 1990 1995 2000
H H L
4.4
4.6
4.8
5.0
5.2
5.4
1970 1975 1980 1985 1990 1995 2000
L
L
56
ECB
Wor ki ng Paper Ser i es No. 364
May 2004

The Data
The data frequency is annual. The period covered is 1970 until 2002 for most series and most
countries. We consider 18 countries, which are Australia, Belgium, Canada, Switzerland, Germany,
Denmark, Spain, Finland, France, Ireland, Italy, Japan, Netherlands, Norway, New Zealand, Sweden,
US and UK. The asset price indices have been kindly supplied by Steve Arthur and Claudio Borio
from the BIS (See Borio, Kennedy and Prowse (1994) and Borio and Lowe (2001) on these indices).
The aggregate indices are weighted by the actual share of the asset components (equity, residential
property, commercial property) in the respective economy. We used the real asset price indices as
deflated by consumer prices by the BIS.

The following data are from the OECD Economic Outlook, with the series code in parenthesis:
Real private consumption (CPV), consumer prices (CPI), the nominal effective exchange rate
(EXCHEB), real housing investment (IHR), real private investment (IPV), a broad monetary aggregate
(MONEYS), the short term interest rate (IRS), nominal and real GDP (GDP and GDPV). We
corrected the German growth rates for GDP, investment, housing investment and consumption for the
unification effect in 1991, using the West German growth rate for 1991.
Domestic credit is from the IMFs International Financial Statistics, code 32. For the euro area
countries domestic credit has been updated from 1999 until 2002 with growth rates obtained from the
ECBs Monetary Transmission Network database. The credit series showed huge structural breaks.
Whenever the IFS codes signalled a structural break and simultaneously the TRAMO software
indicated a structural break (level shift) based on the time series characteristics, we let TRAMO
estimate the size of the structural break and used the (backward) corrected data. Credit data for
Belgium, France and the Netherlands are interpolated for the year 1998.
Monetary aggregates for the Euro Area countries are M3 data from the ECBs Monetary Transmission
Network database.
For France, UK, Ireland, Italy and Denmark interest rates are form the AMECO database. In order to
use longer time series to improve the trend estimates for the early periods we used the IFS money
market rate, line 60b, assuming parallel shifts in the yield curve for the following countries:
Switzerland 1969-1973, Spain 1974-1976, Norway 1972-1978 and Sweden 1966-1981.
The rate of change of the real effective exchange rate is computed by simply adding the growth rates
of nominal effective exchange rate index and domestic inflation. It thus neglects price developments
of trading partners.
The real interest rate is simply the difference between the short term interest rate and current inflation.

The ratios to GDP for output components were computed by dividing the real variable by real GDP.
The ratios for the nominal variables, money and credit were computed as ratios to nominal GDP. The
57
ECB
Wor ki ng Paper Ser i es No. 364
May 2004

recursive trends were derived by extending the window for the HP filter period by period. The starting
window for the first (non-recursive) trend estimates were the following, 1970-1975 for the real
aggregate asset price indices, interest rates as well as the monetary aggregate and from as early as data
were available (usually 1963) until 1970 for all other variables. The base periods differ slightly due to
missing data availability for some countries with regard to the respective variable: the base period for
interest rates for Spain and New Zealand is 1974-1979 and for Norway 1972-1977. The TRAMO
software needs a minimum of 12 observations to identify an ARIMA model. Thus the base window to
calculate the HP trend was extended accordingly.
There were three cases where we artificially overturned the automatic boom identification. For New
Zealand in 1985 the real aggregate asset price gap fell below 10% due to a massive hike in inflation
while nominal asset prices continued to rise. We chose to prolong rather than interrupt the boom so
that the whole period 84-87 can be considered as one instead of two (84 and 86-87) booms. Similar
argumentation applied to Ireland 1988 and Norway 1999. In both years real asset prices were still
rising although falling below the threshold due to the increase in the trend. In order to maintain a
continuous boom period we classified these two years also as boom years.
The equity price gap for Spain between 1983-1986 is the percent difference using the average of the
trend and the series as opposed to log differences as the trend turned out to be negative in this period.

The five different measures of the Taylor gaps (two of which forecast based) are defined as follows,
where i is the nominal interest rate, r the real interest rate, the inflation rate, y real GDP and
variables with a star denote trend values:
Taylor gap X: i
t
[r
t
* +
t
+ 0.5(
t
-
t
*) + 0.5(y
t
y
t
*)], where r*, * and y* are the ex-post HP
trends derived with =100.
Taylor gap R: i
t
[r
t
* +
t
+ 0.5(
t
-
t
*) + 0.5(y
t
y
t
*)], where r*, * and y* are the recursive HP
trends derived with =1000.
Taylor gap T: i
t
[r
t
* +
t
+ 0.5(
t
-
t
*) + 0.5(y
t
y
t
*)], where r*, * and y* are the recursive HP
trends derived with =1000 where at each point in time the optimal ARIMA model for each of the
three variables is identified (by TRAMO) in order to produce a three period forecast. The recursive
HP trend for each period in time is then derived using the series including three forecast values,
extending the current sample edge.

F-Taylor gap R: i
t
[r
t
* +
t
+ 0.5(
t

t+1
-
t

t+1
*) + 0.5(
t
y
t+1

t
y
t+1
*)], where r* is the recursive HP
trend derived with =1000.
t

t+1
and
t
y
t+1
are the one period ahead forecasts derived by an optimised
ARIMA model, which is newly identified for each country at each point in time (by TRAMO).
t

t+1
*
and
t
y
t+1
* are one period ahead forecasts of the HP trend using again an optimised ARIMA model.
F-Taylor gap T: This is the same as F-Taylor gap R, except that three period optimised ARIMA model
forecasts are used to derive the HP trends * and y* before the one period forecasts of
t

t+1
* and
t
y
t+1
*
are computed.
The following abbreviations apply to Tables A2a-A6d:
AvPre = average of two pre-boom years; Av B = average of boom years; AvPst = average of two post boom years; Pre2 = the
year two years before the boom; Pre1 = the year before the boom; B1B5 = the firstfifth boom year; Last = the last boom
year; Post1 = the first year after the boom; Post2 = the second year after the boom; Av.B-Av.Pr = the average of the boom
period minus the average of the pre boom period; Av.Ps-Av.B = the average of the post boom period minus the average of
the boom period; Last-Pre2 = the last year minus the year two years before the boom; Ps2-Last = the second year after the
boom minus the last year of the boom; Norm = all other periods in the sample.
The Wilcoxon-Mann-Whitney Test
The Wilcoxon-Mann-Whitney test is a non-parametric test for differences in populations. The
assumptions are simply that each sample is a random sample from the population it represents, that the
two samples are independent from each other and that the measurement scale is at least ordinal.
To derive the test statistic one first combines the two series and then orders all observations by size.
Then one computes the sum of the ranks (in the combined series) for the two samples. The null
hypothesis that there is no difference between the two populations will be rejected when the sum of
the ranks of the two samples is relatively different. If the number of observations in at least one of the
two samples exceeds 10 (see e.g. Newbold et al., 2003), which is always true in our case, the test
statistic quickly approaches a normal distribution. The test statistic used for a two-sided test is
12 / ) 1 (
2 / ) 1 ( 5 . 0
+
+
=
N mn
N m W
z
x
, where W
x
is the sum of the ranks of the smaller sample, m and n are
the number of observations in the smaller and larger sample, respectively and N=m+n.
Under the additional assumption that the only difference between the two populations is the mean, the
Wilcoxon-Mann-Whitney test can be interpreted as a test for equality of means. Even in this case it is
more powerful than a standard two sample t-test for small samples as it does not require the normality
assumption. The tests have been applied to all periods except the third, fourth and fifth boom years.
Table A7 shows that the sample for high- and low-cost booms gets too small to draw reasonable
conclusions.
Table A7
Sample size for different periods: overall, high and low cost booms
B1, Last, all others B2 B3 B4 B5 Norm
Overall 38 31 20 17 10 about 240
High cost 14 11 9 8 5 -
Low cost 24 20 11 9 5 -
58
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
59
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
302 Deposit insurance, moral hazard and market monitoring by R. Gropp and J. Vesala, February 2004.

303 Fiscal policy events and interest rate swap spreads: evidence from the EU by A. Afonso and
R. Strauch, February 2004.
304 Equilibrium unemployment, job flows and inflation dynamics by A. Trigari, February 2004.

305 A structural common factor approach to core inflation estimation and forecasting
by C. Morana, February 2004.
306 A markup model of inflation for the euro area by C. Bowdler and E. S. Jansen, February 2004.

307 Budgetary forecasts in Europe - the track record of stability and convergence programmes
by R. Strauch, M. Hallerberg and J. von Hagen, February 2004.

308 International risk-sharing and the transmission of productivity shocks by G. Corsetti, L. Dedola
and S. Leduc, February 2004.

309 Monetary policy shocks in the euro area and global liquidity spillovers by J. Sousa and A. Zaghini,
February 2004.

310 International equity flows and returns: A quantitative equilibrium approach by R. Albuquerque,
G. H. Bauer and M. Schneider, February 2004.

311 Current account dynamics in OECD and EU acceding countries an intertemporal approach
by M. Bussire, M. Fratzscher and G. Mller, February 2004.
European Central Bank working paper series
For a complete list of Working Papers published by the ECB, please visit the ECBs website
(http://www.ecb.int).

312 Similarities and convergence in G-7 cycles by F. Canova, M. Ciccarelli and E. Ortega,
February 2004.

313 The high-yield segment of the corporate bond market: a diffusion modelling approach
for the United States, the United Kingdom and the euro area by G. de Bondt and D. Marqus,
February 2004.

314 Exchange rate risks and asset prices in a small open economy by A. Derviz, March 2004.

315 Option-implied asymmetries in bond market expectations around monetary policy actions of the ECB

by S. Vhmaa, March 2004.

60
ECB
Wor ki ng Paper Ser i es No. 364
May 2004

321 Frequency domain principal components estimation of fractionally cointegrated processes
by C. Morana, March 2004.

322 Modelling inflation in the euro area by E. S. Jansen, March 2004.
323 On the indeterminacy of New-Keynesian economics by A. Beyer and R. E. A. Farmer, March 2004.
324 Fundamentals and joint currency crises by P. Hartmann, S. Straetmans and C. G. de Vries, March 2004.
325 What are the spill-overs from fiscal shocks in Europe? An empirical analysis by M. Giuliodori
and R. Beetsma, March 2004.
326 The great depression and the Friedman-Schwartz hypothesis by L. Christiano, R. Motto and
M. Rostagno, March 2004.
327 Diversification in euro area stock markets: country versus industry by G. A. Moerman, April 2004.
328 Non-fundamental exchange rate volatility and welfare by R. Straub and I. Tchakarov, April 2004.
329 On the determinants of euro area FDI to the United States: the knowledge-capital-Tobin's Q framework,
by R. A. De Santis, R. Anderton and A. Hijzen, April 2004.
330 The demand for euro area currencies: past, present and future by B. Fischer, P. Khler and F. Seitz, April 2004.
331 How frequently do prices change? evidence based on the micro data underlying the Belgian CPI by
L. Aucremanne and E. Dhyne, April 2004.
332 Stylised features of price setting behaviour in Portugal: 1992-2001 by M. Dias, D. Dias
and P. D. Neves, April 2004.
316 Cooperation in international banking supervision by C. Holthausen and T. Rnde, March 2004.

317 Fiscal policy and inflation volatility by P. C. Rother, March 2004.

318 Gross job flows and institutions in Europe by R. Gmez-Salvador, J. Messina and G. Vallanti, March 2004.

319 Risk sharing through financial markets with endogenous enforcement of trades by T. V. Kppl, March 2004.

320 Institutions and service employment: a panel study for OECD countries by J. Messina, March 2004.
333 The pricing behaviour of Italian firms: New survey evidence on price stickiness by
S. Fabiani, A. Gattulli and R. Sabbatini, April 2004.
334 Is inflation persistence intrinsic in industrial
economies? by A. T. Levin and J. M. Piger, April 2004.
335 Has eura-area inflation persistence changed over time? by G. OReilly and K. Whelan, April 2004.
336 The great inflation of the 1970s by F. Collard and H. Dellas, April 2004.
337 The decline of activist stabilization policy: Natural rate misperceptions, learning and expectations by
A. Orphanides and J. C. Williams, April 2004.
61
ECB
Wor ki ng Paper Ser i es No. 364
May 2004
338 The optimal degree of discretion in monetary policy
by S. Athey, A. Atkeson and P. J. Kehoe, April 2004.
339 Understanding the effects of government spending on consumption by J. Gal, J. D. Lpez-Salido
and J. Valls, April 2004.
340 Indeterminacy with inflation-forecast-based rules in a two-bloc model by N. Batini, P.Levine
and J. Pearlman, April 2004.
341 Benefits and spillovers of greater competition in Europe: A macroeconomic assessment by T. Bayoumi,
D. Laxton and P. Pesenti, April 2004.
342 Equal size, equal role? Interest rate interdependence between the euro area and the United States by
M. Ehrmann and M. Fratzscher, April 2004.
343 Monetary discretion, pricing complementarity and dynamic multiple equilibria by R. G. King
and A. L. Wolman, April 2004.
344 Ramsey monetary policy and international relative prices by E. Faia and T. Monacelli, April 2004.
345 Optimal monetary and fiscal policy: A linear-quadratic approach by P. Benigno and M. Woodford, April 2004.
346 Perpetual youth and endogenous labour supply: a problem and a possible solution by G. Ascari and
N. Rankin, April 2004.
347 Firms investment decisions in response to demand and price uncertainty by C. Fuss
and P. Vermeulen, April 2004.
348 Financial openness and growth: Short-run gain, long-run pain? by M. Fratzscher and M. Bussiere, April 2004.
349 Estimating the rank of the spectral density matrix by G. Camba-Mendez and G. Kapetanios, April 2004.
350 Exchange-rate policy and the zero bound on nominal interest rates by G. Camba-Mendez
and G. Kapetanios, April 2004.
351 Interest rate determination in the interbank market by V. Gaspar, G. P. Quirs and
H. R. Mendizbal, April 2004.
352 Forecasting inflation with thick models and neural networks by P. McNelis and
P. McAdam, April 2004.
353 Towards the estimation of equilibrium exchange rates for CEE acceding countries: methodological
issues and a panel cointegration perspective by F. Maeso-Fernandez, C. Osbat and B. Schnatz, April 2004.
354 Taking stock: monetary policy transmission to equity markets by M. Ehrmann and M. Fratzscher, May 2004.
355 Production interdependence and welfare by K. X. D. Huang and Z. Liu, May 2004.
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ECB
Wor ki ng Paper Ser i es No. 364
May 2004
356 Developing a euro area accounting matrix: issues and applications by T. Jellema, S. Keuning,
P. McAdam and R. Mink, May 2004.
357 Seasonal adjustment and the detection of business cycle phases by A. M. Mir and
D. R. Osborn, May 2004.
358 Did the pattern of aggregate employment growth change in the euro area in the
late 1990s? by G. Mourre, May 2004.
359 The longer term refinancing operations of the ECB by T. Linzert, D. Nautz and U. Bindseil,
May 2004.
360 Optimal monetary policy rules for the euro area: an analysis using the area wide model
by A. Dieppe, K. Kster and P. McAdam, May 2004.
361 Excess reserves and the implementation of monetary policy of the ECB by U. Bindseil,
G. Camba-Mendez, A. Hirsch and B. Weller, May 2004.
362 Oil price shocks and real GDP growth: empirical evidence for some OECD countries by
R. Jimnez-Rodrguez and M. Snchez, May 2004.
363 Communication and exchange rate policy by M. Fratzscher, May 2004.
364 Asset price booms and monetary policy by C. Detken and F. Smets, May 2004.