Should Monetary Policy Respond To Asset Price Bubbles? Revisiting the Debate (original) (raw)

How should monetary policy respond to asset-price bubbles?

2005

We present a simple macroeconomic model that includes a role for an asset-price bubble. We then derive optimal monetary policy settings for two policymakers: a skeptic, for whom the best forecast of future asset prices is the current price; and an activist, whose policy ...

Lean-Against-the-Wind Monetary Policy: The Post-Crisis Shift in the Literature

2015

The debate concerning central banks’ response to potential asset price bubbles initially referred to whether monetary policy should respond at a level over and above the one warranted by the objectives of inflation and output gap stability, trying to slow the growth of perceived asset price bubbles, so as to minimise the adverse effects when the latter burst (the ‘lean-against-the-wind’ -LATW- view). Alternatively, it argued whether it should respond to declines in asset prices only after the bubble bursts (often termed as conventional or ‘cleaning-up’ view), in order to stabilise both output and inflation. The article reviews the shift in the monetary policy literature addressing the above debate in the aftermath of the global financial crisis, and demonstrates that this shift has been in favour of the LATW view. In particular, we contend that the pre-crisis conventional view has incorporated elements of the opposing view, in that it addresses financial frictions in the models of t...

Rethinking Monetary Stabilization in the Presence of an Asset Bubble

SSRN Electronic Journal, 2000

This paper addresses three important questions: how should monetary policy respond to stock market booms, what causes stock market bubbles and can monetary policy pop them. These questions arose during the recent stock market bubble during 1995-2000 and its collapse during 2000-1. To answer these questions we rapidly review the lessons learned from the Fed's response to the stock market boom in the 1920s and the lessons learned from the response of the Bank of Japan in the 1990s. The conclusion of the paper is that an asymmetric response of monetary policy to the stock market booms is appropriate: neutral in stock market booms unless they cause inflation, monetary ease after a stock market bust to dampen the effect on output and if necessary to provide liquidity to the financial system. The theoretical bubble literature and the U.S. experience in the 1920s provides little evidence that monetary policy can pop bubbles and attempting do so is potentially costly in terms of lost output.

Asset Price Bubbles and Central Bank Policies: The Crash of the'Jackson Hole Consensus

This paper reexamines the main arguments of whether or not monetary policy should respond to asset bubbles. The question of how the central bank should respond to an asset bubble can be reformulated in two ways. First, how does the central bank respond while an asset bubble is growing, and second, how does it respond after the bubble bursts? There has been strong agreement among economists that a central bank should respond to the bursting of a bubble by aggressively decreasing the Fed funds rate to minimize the adverse impact of financial instability on the real economy. However, there is no clear answer to the question of how the central bank should respond to an asset bubble before it bursts. If there is evidence that the asset price bubble is contributing to inflation, then there is general agreement that the central bank should respond. But what if prices remain stable? These issues are critically reviewed and the conclusion is reached that the high costs associated with the 2007-2009 financial crisis have encouraged the development of a new central bank policy paradigm that encourages -leaning against bubbles‖ and giving due consideration to alternative tools other than interest rate policy tools.

Pricking Bubbles in the Wind: Could Central Banks Have Done More to Head Off the Financial Crisis?

Australian Economic Review, 2009

Regulators, commercial and investment banks, hedge funds and rating agencies have all borne some blame for the current global financial crisis, but could central banks have done more? It is argued in the lecture that in a number of ways central banks should have paid more attention to asset bubbles, which have high output costs. Asset prices, especially housing prices, should be identified as an explicit factor in the consideration of policy. More generally, central banks should adopt policies that 'lean against the wind'.

Monetary Policy and Asset Prices: More Bad News for ?Benign Neglect?

International Finance, 2007

In this paper we explore the optimal policy reaction to boom-bust cycles in asset prices. Bordo and Jeanne (2002a, b) point to the risks of a reactive strategy that only mitigates the consequences of a crisis if and when it occurs. Acting pre-emptively by rigorously counteracting the build-up of the crisis scenario may be superior in welfare terms. We show that even a purely reactive monetary policy involves an ex ante response to a possible asset price crash. The reason, however, is not the attempt to avoid real and financial disruption but to react optimally to changes in private sector's expectations. Furthermore, we find that the welfare losses of a reactive strategy increase when forward-looking expectations are taken into account while the welfare implications of a pro-active strategy do not change. for detailed expositions and discussions of the microeconomic foundation of the New Keynesian models. 5 BJ (2002a, b) introduced this idea. 6 Staggered price setting was introduced by Calvo (1983).