Financial System Liquidity, Asset Prices and Monetary Policy

Monetary policy works through changes in asset prices – especially through its impact on long-term interest rates. As well as affecting the economy through the usual ‘IS’ relationships – through consumption and investment – monetary policy has wider repercussions. It affects balance sheets through changes in the relative prices of liabilities and assets, the availability of credit and through property prices – a set of interrelated features that we can dub ‘fi nancial system liquidity’. When balancesheet changes affect asset prices, and asset-price changes affect balance sheets, the loop thus created can generate amplifi ed responses to an easing of monetary policy that cannot easily be unwound without exacting large economic costs.