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Monetary Policy and Herd Behavior: Leaning Against Bubbles

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  • Loisel, O.
  • Pommeret, A.
  • Portier, T.

Abstract

We study the role of monetary policy when asset-price bubbles may form due to herd behavior in investment in an asset whose return is uncertain. To that aim, we build a simple general-equilibrium model whose agents are households, entrepreneurs, and a central bank. Entrepreneurs receive private signals about the productivity of the new technology and borrow from households to publicly invest in the old or the new technology. The three main results of the paper are that bubbles (informational cascades) can occur in this general equilibrium setting; that the central bank can detect them even though it has directly access to less information than the investors; and that the central bank can eliminate bubbles by manipulating the interest rate. Indeed, monetary policy, by affecting the investors' cost of resources, can make them invest in the new technology if and only if they receive an encouraging private signal about its productivity. In doing so, it makes their investment decision reveal their private signal, and therefore prevents herd behavior and the asset-price bubble. We also show that such a “leaning against the wind" monetary policy, contingent on the central bank's information set, may be preferable to laisser-faire, in terms of ex ante welfare.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 412.

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Length: 58 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:bfr:banfra:412

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Keywords: Monetary Policy – Asset Prices – Informational Cascades – Bubbles.;

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  1. Christiano, Lawrence & Ilut, Cosmin & Motto, Roberto & Rostagno, Massimo, 2008. "Monetary policy and stock market boom-bust cycles," Working Paper Series 0955, European Central Bank.
  2. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  3. V. V. Chari & Patrick J. Kehoe, 2003. "Financial crises as herds: overturning the critiques," Staff Report 316, Federal Reserve Bank of Minneapolis.
  4. Gilchrist, Simon & Leahy, John V., 2002. "Monetary policy and asset prices," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 75-97, January.
  5. Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
  6. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
  7. Avery, Christopher & Zemsky, Peter, 1998. "Multidimensional Uncertainty and Herd Behavior in Financial Markets," American Economic Review, American Economic Association, vol. 88(4), pages 724-48, September.
  8. Decamps, Jean-Paul & Lovo, Stefano, 2006. "Informational cascades with endogenous prices: The role of risk aversion," Journal of Mathematical Economics, Elsevier, vol. 42(1), pages 109-120, February.
  9. Gale, D. & Chamley, C., 1992. "Information Revelation and Strategic Delay in a Model of Investment," Papers 10, Boston University - Department of Economics.
  10. Beaudry, Paul & Portier, Franck, 2001. "An Exploration into Pigou's Theory of Cycles," CEPR Discussion Papers 2996, C.E.P.R. Discussion Papers.
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Cited by:
  1. Luisa Lambertini & Caterina Mendicino & Maria Tereza Punzi, 2011. "Leaning Against Boom-Bust Cycles in Credit and Housing Prices," Working Papers w201108, Banco de Portugal, Economics and Research Department.
  2. Itai Agur & Maria Demertzis, 2013. "Leaning Against the Wind and the Timing of Monetary Policy," IMF Working Papers 13/86, International Monetary Fund.

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