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Monetary Policy and Asset Price Bubbles

Final Report Summary - BUBPOL (Monetary Policy and Asset Price Bubbles)

The objectives of the BUBPOL project are twofold. Firstly, the development of a framework that may be used to analyze rigorously the implications of alternative monetary policy rules in the presence of asset price bubbles. Secondly, the assessment of the evidence regarding the effects of monetary policy on asset price bubbles.

Significant progress in attaining the first objective has been made in “Monetary Policy and Rational Asset Price Bubbles,” where an overlapping generations model with nominal rigidities is developed. The analysis of the equilibrium of the model shows that a systematic increase in interest rates in response to a growing bubble enhances the fluctuations in the latter, introducing unnecessary fluctuations in consumption. That analysis has been extended in “Monetary Policy and Bubbles in a New Keynesian Model with Overlapping Generations” using a richer, more realistic framework in which fluctuations in output and employment may emerge as a result of fluctuations in the aggregate bubble. In that context, monetary policies that lean against the bubble are shown to be potentially destabilizing, and likely to be dominated by inflation targeting policies. All things considered, the theoretical findings of this first part of the BUBPOL project call into question the theoretical foundations of the case for "leaning against the bubble" monetary policies.

The second objective of BUBPOL, i.e. coming up with evidence on the effects of monetary policy on asset price bubbles, has been addressed in my paper “The Effects of Monetary Policy on Stock Market Bubbles some Evidence” (with L. Gambetti). In that paper we provide econometric evidence pointing to protracted episodes in which stock prices end up increasing persistently in response to an exogenous tightening of monetary policy. That response is clearly at odds with the "conventional" view on the effects of monetary policy on bubbles, as well as with the predictions of bubbleless model, but is consistent with the predictions of a sticky price model with rational bubbles.

In ongoing work with G. Giusti and C. Noussair, we have produced experimental evidence on the effects of interest rates on asset price bubbles, through the development of an environment in the lab in which participants make portfolio decisions involving deposits (yielding an interest rate under our control) and a “bubble asset,” i.e. an asset which does not generate any dividends ever, but for which participants in the experiments are willing to pay a positive price, given the expectation of an eventual resale at a higher price. The analysis of the evolution of the observed bubble and its relation to interest rate changes suggests significant deviations from the predictions of a model with rational expectations, with individual decisions seemingly being driven by expectations influenced by past trends.