Asset price bubbles and monetary policy: Revisiting the nexus at the zero lower bound

Abstract

Asset price bubbles are a major source of macroeconomic instability, but can they play a stabilizing role in a low interest rates environment? To answer this question, I study an economy in which the natural rate of interest declines permanently and a long-lasting zero lower bound (ZLB) episode makes risk-free interest rates persistently low. Asset price bubbles redistribute wealth across generations because of the life-cycle pattern of net worth. In this way, they increase the natural interest rate by serving as a store of value for older cohorts and as a collateral for the younger ones, and the central bank can escape from the ZLB with consequent output gains. Therefore, the redistribution of wealth/consumption across generations, which would be welfare-reducing in normal times, becomes welfare-enhancing. However, asset price bubbles affect mainly the natural interest rate through their role of collateral, and a leveraged bubble is the most detrimental for output when it crashes (Jordá et al., 2015).

Rational housing demand bubble

“…In contrast to Bonchi (2022), a housing demand bubble does not allow a central bank to escape from the zero lower bound. 7 Our result also means that an expansionary monetary policy where a central bank lowers interest rates to zero to stimulate the economy will create an excess of bond demand and makes room for the existence of a housing demand bubble. This result contrasts with Gali (2014), who argues that the monetary authority should lower the nominal interest rates when the bubble grows to stabilize the economy.…”

“…Since houses purchased by young households provide strictly positive dividends in terms of housing services, the return factor of houses purchased when young R t+1 is strictly greater than the return factor of housing demand bubble R h t+1 ( R t+1 > R h t+1 ). Using ( 6) and (7), Inequality (8) rewrites:…”

“…In a three-period OLG model,Bonchi (2022) studies how a pure asset bubble affects monetary policy by relaxing the zero lower bound constraint. Despite financial frictions, the author shows that a pure bubble occurs when the interest rate is lower than the growth rate of the economy in the bubbleless steady state asTirole (1985), and raises the interest rate.…”