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Financial Fragility, Bubbles and Monetary Policy

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  • Gerhard Illing
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    Abstract

    The paper models the links between financial fragility, asset markets and monetary policy. It is shown that central banks concern about the cost of financial disruption generates an asymmetric response, thus contributing to the creation of an asset price bubble. In an economy with a highly leveraged financial structure, the central bank has an incentive to prevent a run on financial intermediation by injecting liquidity when asset values fall significantly. The inflationary side effect of this policy reduces the real value of nominal debt and so gives rise to a put option for investors, driving up asset prices above their fundamental value. The paper shows that the size of such a bubble is likely to be rather small. The bubble is only equal to the expected value of capital gains on outstanding debt, which are fairly limited in a crisis. Since, in contrast, the gains from preventing the disruption of financial intermediation can be quite large, it is rational for a central bank to inject liquidity in a crisis.

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    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2001/wp-cesifo-2001-04/cesifo_wp449.pdf
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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 449.

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    Date of creation: 2001
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    Handle: RePEc:ces:ceswps:_449

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    Related research

    Keywords: Asset bubbles; monetary policy; financial stability;

    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. E.P. Davis, 2000. "Financial Stability in the Euro Area: Some Lessons from US Financial History," FMG Special Papers sp123, Financial Markets Group.
    2. Cecchetti, Stephen G. & Kashyap, Anil K, 1996. "International cycles," European Economic Review, Elsevier, vol. 40(2), pages 331-360, February.
    3. Timothy Cogley, 1999. "Should the Fed take deliberate steps to deflate asset price bubbles?," Economic Review, Federal Reserve Bank of San Francisco, pages 42-52.
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    Cited by:
    1. Zhou, Ge, 2011. "Rational bubbles and the spirit of capitalism," MPRA Paper 33988, University Library of Munich, Germany.
    2. Schnabl, Gunther & Hoffmann, Andreas, 2007. "Monetary Policy, Vagabonding Liquidity and Bursting Bubbles in New and Emerging Markets - An Overinvestment View," MPRA Paper 5201, University Library of Munich, Germany.
    3. Eric Tymoigne, 2006. "Asset Prices, Financial Fragility, and Central Banking," Economics Working Paper Archive wp_456, Levy Economics Institute.
    4. Gerhard Illing & Ulrich Klüh, 2005. "Vermögenspreise und Konsum: Neue Erkenntnisse, amerikanische Erfahrungen und europäische Herausforderungen," Perspektiven der Wirtschaftspolitik, Verein für Socialpolitik, vol. 6(1), pages 1-22, 02.
    5. Grégory Levieuge, 2005. "Politique monétaire et prix d'actifs," Revue de l'OFCE, Presses de Sciences-Po, vol. 93(2), pages 317-355.

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