Asset bubbles and monetary policy

Abstract

We provide an infinite-horizon model of rational asset bubbles in a Dynamic New Keynesian framework. Entrepreneurs are heterogeneous in investment efficiency and face credit constraints. They can trade land as an asset, which also serves as collateral to borrow from banks with reserve requirements. Land commands a liquidity premium and a land bubble can emerge. Monetary policy can affect the condition for the existence of a bubble, its steady-state size, and its dynamics including the initial size. The 'leaning against the wind' interest rate policy will reduce the bubble volatility, but it may come at the cost of raising the inflation volatility. Whether monetary policy should respond to asset bubbles depends on the particular interest rate rule adopted by the central bank and on the exogenous shocks hitting the economy.

Asset Price Learning and Optimal Monetary Policy

“…Raising interest rates when subjective beliefs are overly optimistic reduces the price of our long-term asset, thereby correcting expectations downwards. This finding is in contrast to the rational bubble literature (Gali, 2014;Dong et al, 2017), where raising rates when bubbles are large makes them larger still.…”

Asset Price Learning and Optimal Monetary Policy

“…He cautions against a positive reaction of interest rates to bubbles because bubbles grow faster when interest rates are raised. Consistent with that intuition, Dong et al (2017) find that a negative reaction of interest rates to asset prices is optimal in a model with liquidity bubbles in the presence of collateral constraints. Yet, rational bubbles are not the only way through which asset prices can deviate from their "fundamental value".…”

“…We find that this reaction generally mitigates the distortions from non-rational beliefs and stabilizes asset price fluctuations. This latter finding is in direct contrast to Gali (2014) and Dong et al (2017): Higher interest rates increase the size of rational bubbles, but decrease subjective price expectations under learning.…”

Monetary Policy and Rational Asset Price Bubbles: Comment

“…We conjecture that learning will select the bubbly steady state and the associated forward-looking solution as in this paper. Miao, Wang, and Xu (2015) and Dong, Miao, and Wang (2017) incorporate recurrent bubbles and show that the economy has a continuum of bubbly steady states as in Galí (2014). However, they are unable to prove the stability of these steady states analytically due to the complexity of their multi-dimensional equilibrium systems.…”