My macroeconomics professor told the following: A decrease in interest rate causes that consumers rather spend their money on investments (stocks, houses) than put the money on the bank, and the increase in demand for stocks and houses causes asset price inflation in return.

However, if I try to search for a scholarly source saying the same thing, I cannot find anything. Is the above reasoning a solid one?

Thank you very much in advance!

  • $\begingroup$ Frankly "asset price inflation" seems to mean different things to different people. So the statement is rather trivially true, or not true just with those assumptions, depending on what is meant by "asset price inflation". $\endgroup$ – SX welcomes ageist gossip Sep 19 '19 at 6:23
  • $\begingroup$ Under the most trivial interpretation of that statement, "elementary finance theory states that if the long-term real interest rate is low, the rate of discount used to determine present values will also be low, and hence present values should be high." jstor.org/stable/27561599 It's what BKay's answer details. $\endgroup$ – SX welcomes ageist gossip Sep 19 '19 at 6:54
  • $\begingroup$ As for other meanings of "asset price inflation" see economics.stackexchange.com/questions/31942/… $\endgroup$ – SX welcomes ageist gossip Sep 19 '19 at 9:41

My understanding of the effect of easing monetary policy on asset prices is that it can work through a more direct channel.

If markets are efficient and risk neutral then generally the value of an asset $i$ is equal to the net present value of the expected cash flows generated by that project: $$ P_i = NPV(i) = \sum_{\tau=0}^{\infty} \frac{E[C_\tau]}{\Pi_{\ell=0}^{\tau}(1+r_{\ell})} $$ Monetary policy directly lowers the denominator of the the fraction in the sum, so it raises the value of the sum. In English, by reducing the rate at which we discount future investment the present value of the asset's cash flows become more valuable. If monetary policy can also improve the economy more generally, it can also increase the expected size of the cash flows, further increasing the value of the asset (it also raises the numerator).

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  • $\begingroup$ I'm not sure this argument is that conving by itself because an improving economy also causes (regular) inflation. So it depends if you want to call any nominal price increase of assets, "asset price inflation". If asset prices rise in nominal terms, but still lower than the CPI, is that still "asset price inflation"? (Compared to "the average stuff" in the economy, the assets are actually cheaper now.) $\endgroup$ – SX welcomes ageist gossip Sep 19 '19 at 5:56
  • $\begingroup$ "Asset inflation occurs when the prices of financial assets are rising even though they are already above their intrinsic or underlying value. Hence, to establish asset inflation, the intrinsic value of equities and houses must be first determined." bis.org/publ/confp05n.pdf $\endgroup$ – SX welcomes ageist gossip Sep 19 '19 at 6:03

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