There are three other categories of asset prices besides those on debt instruments that are regarded as critical channels through which monetary policy affects the economy.
Changes in these asset prices affect investment and consumption decisions of both firms and households and therefore central banks often use it as an instrument of monetary policy.
Fluctuations in the stock market have important impacts on the economy, so also when influenced by Central Bank monetary policies.
Under these circumstances, firms can issue stocks and get a high price for it, relatively to what it costs to buy the facilities and equipment that they need.
As a result, investment spending will rise and firms buy this new equipment with only a small issue of stocks.
Expansionary monetary policy (a lower interest rate) make stocks relatively more attractive than bonds.
As was explained above, this raises the level of investment spending of firms, thereby leading to an increase in aggregate demand and a rise in output.
This increases the risk of moral hazard and adverse selection problems for firms with a lower net worth.
Therefore, a decline in net worth increases moral hazard and adverse selection problems and may lead to less lending to finance investment spending.
Expansionary policy rises the stock prices of the firm, which increases the net worth of the company.
This decreased problems of moral hazard and adverse selection which means that funds to finance investments can rise.
Expansionary monetary policy will cause the interest rate in a country to fall and deposits that are denominated in that domestic currency become less attractive than their foreign equivalents.
As a result of this depreciation (domestic products become cheaper), net exports will rise and consequently so will aggregate spending.
This again increases the problems of moral hazard and adverse selection and therefore will drive the amount of funds available through lending down.
Real estate prices can affect the output of an economy via three different routes: 1) effects on housing expenditures, 2) household's wealth and 3) bank balance sheets.
As we saw in Modigliani's lifecycle consumption theory before, houses are also a very important component of a households’ financial wealth.