Maria Socorro Gochoco-bautista

**Discipline: **Economics, Social Science, Finance

The US financial crisis was largely unexpected, with effects that have not been confined to the financial sector and that have extended well beyond its borders. This highlights the need for central bankers to understand the causes of the crisis in order to determine the best possible responses to the present situation. The role of asset prices in the economy and its implications for the conduct of monetary policy is essential. This paper examines whether asset price booms significantly raise the probability at the margin of the realization of extreme outcomes in output and prices. It also assesses whether the worst outcomes are just as likely to occur as the good ones, using quarterly data for eight East Asian economies. Extreme outcomes are found in the tails of a probability distribution. The Expected Tail Loss (ETL) derived from the set of worst outcomes is the expected loss conditional on being in the lowest quantile of the distribution. In the case of the gross domestic product (GDP), for example, expected outputs substantially below trend are found in the left tail of the probability distribution of the GDP gap. Similarly, expected price level outcomes substantially above trend are found in the right tail of the probability distribution of the price level gap. The empirical results of the study show that: (1) asset price booms in housing and equity markets, especially in housing, significantly raise the probability at the margin that the real output- and price-level gaps will be in the tails of worst outcomes of their respective distributions; (2) the risks arising from asset booms are not symmetric, as only the risk of particularly bad outcomes increases; and (3) since real output and price-level gaps exhibit ‘fat tails,' expected real output and price level outcomes obtained without conditioning on asset price booms or obtained conditional on asset price booms but using the normal approximation, underestimate the risk of tail events and lead to less pessimistic, albeit misleading inferences. The paper concludes that policymakers need to adopt a risk management approach to monetary policy and in particular, to minimize the risk of realizing the worst outcomes in output and prices when asset prices rise suddenly. Thus, building better institutional structures to be able to withstand large shocks should be part of the continuing agenda of monetary policymakers and bank regulators in the Asian region.