Monetary Policy and Rational Asset Price Bubbles (Digest Summary)

The objective of the research is to determine whether monetary policy can affect the conditions necessary for the existence or nonexistence of an asset bubble. The author calls into question the theoretical foundations of the case for “leaning against the wind” monetary policies. A “leaning against the wind” policy represents a monetary policy enacted by central banks to change interest rates to adjust or contain an asset bubble. The author develops an overlapping-generations (OLG) model that applies nominal rigidities to aid in understanding partial equilibrium examples in which certain variables are held constant. Furthermore, he explores the impact of monetary policy on bubble dynamics and the optimal monetary policy in the bubbly economy.

The author makes several important conclusions. First, monetary policy cannot affect the necessary conditions for the existence or nonexistence of an asset bubble, but it can influence its short-run behavior, including the size of its fluctuations.

Second, a stronger interest rate response to asset-bubble fluctuations or a “leaning against the wind” policy may raise the volatility of asset prices and their bubble components. The author concludes that changing the interest rate would not be enough to adjust asset bubbles and could result in collateral damage in the form of lower prices for assets not affected by the bubble as well as cause a greater risk of an economic downturn. The real economy and asset-price bubbles are actually affected by the real interest rate driven by the real economy components and not monetary policy. The author also concludes that monetary policy has a neutral effect on the real interest rate, and the real interest rate evolves independently of the monetary policy rule. His research confirms other published research on the subject, most notably the analogous results of Samuelson (Journal of Political Economy 1958) and Tirole (Econometrica 1985).

Third, the optimal monetary policy must strike a balance among stabilization of current aggregate demand, which calls for a positive interest rate response to the asset-bubble prices; stabilization of the bubble itself; and, in turn, stabilization of future aggregate demand. These factors warrant a negative interest rate response to the asset-price bubble. The author further concludes that if the average size of the bubble is sufficiently large, the stabilization motive will be dominant, making it optimal for the central bank to lower interest rates in the face of a growing asset-price bubble.

The first part of the methodology is made up of a partial-equilibrium asset pricing example that considers an economy with risk-neutral investors and an exogenous, time-varying gross-riskless rate. The example also denotes the price in a time period of an infinite-lived asset, yielding a dividend stream. The author decomposes the asset price into two components—the fundamental component and the bubble component—with several assumptions holding certain factors constant. He also analyzes the asset-price bubbles in an OLG model without capital and in which labor is supplied inelastically as a laboratory for the analysis of the impact of monetary policy on asset-pricing bubbles. In the OLG model, the methodology considers consumers and each individual lives for two periods. The first period represents their birth and the second period the harvesting period for their firm sale. The OLG model also considers firms in which each individual produces a differentiated good and sets up a firm that becomes productive after the first period of each individual’s (or consumer’s) life span. The third OLG model consideration is the interaction of the real economy with a central bank’s monetary policy.

In the second part of the methodology, the author considers the equilibrium to derive the model’s remaining equilibrium conditions and equilibrium dynamics of the deterministic case, the stochastic case, and the sticky-price equilibrium that portrays the goods market clearing condition of the real economy in equilibrium. In the third part, he considers the impact of monetary policy on bubble dynamics. Several considerations are examined to further understand the relationship between monetary policy and asset-price bubble volatility.

In the fourth part of the methodology, the author considers the impact of the optimal monetary policy in a bubble economy. He factors in the following:

• the welfare criterion, which is defined as the unconditional mean of an individual’s lifetime utility;
• monetary policy and welfare losses; and
• the optimal bubble coefficient with respect to the interest rate.

The target audience for this research is economists and researchers in academia, forecasters and policymakers at central banks, and private practitioners in business. The author effectively leverages prior research from notable publications. He also welcomes additional future research because such factors as a varying inflation rate and further efforts at modeling the interaction of credit, bubbles, and monetary policy may add insight into how monetary policy can successfully affect future asset bubbles. The findings make intuitive sense given monetary actions and recent economic events from the subprime crisis to the present recovery.