Question

Give two reasons why it is difficult for bank to monitor asset-price inflartion?

Answer 1

1.) Asset price inflation or more commonly, bubbles is defined as situations in which the price of the asset grows faster than the asset's fundamental value.,Hence the asset considered to be overvalued.

The idea is that prices serve as signals of market conditions, derived by demand and supply: The increase in price signals a shortage of supply; eventually, supply increases, the price drops and there is a new equilibrium in price and quantity.

But, in times of bubbles, prices may not serve as good signals and, thus, may not reflect market conditions or changes in the underlying value of the asset. Instead, the bubble sends out a signal that the asset is more valuable than it actually is.

fundamental value of an asset is not easy to measure. Value of an asset is generally defined as a stream of payments in the form of dividends to the owner over time. Thus, the fundamental value of the asset should be defined as this total expectation of this stream of payments, discounted to present value.

to properly evaluate the presence of a bubble, we should compare the price of an asset to a measure approximating the stream of future dividends.

thus the notable increases and contractions ; may or may not be due to explosive behavior followed by busts.

2)

The price of a house is not the only determinant of the cost of owning it; so, rising house prices do not necessarily indicate that homeownership has become more expensive relative to renting, but may indicate that something has changed in the fundamental value of the house.

Supply conditions in the real estate market, expected appreciation rates, taxes, maintenance costs and mortgage features also affect the volatility of price/rent ratios.

Response of house prices to changes in fundamentals is larger when interest rates are low and in locations where expected price growth is high; so, fast price increases (relative to rent) do not necessarily signal the presence of a bubble.