Why Central Banks Should Not Burst Bubbles
AbstractCentral banks should not be in the business of trying to prick asset price bubbles. Bubbles generally arise out of some combination of irrational exuberance, technological jumps, and financial deregulation (with more of the second in equity price bubbles and more of the third in real estate booms). Accordingly, the connection between monetary conditions and the rise of bubbles is rather tenuous, and anything short of inducing a recession by tightening credit conditions prohibitively is unlikely to stem their rise. Even if a central bank were willing to take that one-in-three or less shot at cutting off a bubble, the cost-benefit analysis hardly justifies such preemptive action. The macroeconomic harm from a bubble bursting is generally a function of the financial system’s structure and stability—in modern economies with satisfactory bank supervision, the transmission of a negative shock from an asset price bust is relatively limited, as was seen in the United States in 2002. However, where financial fragility does exist, as in Japan in the 1990s, the costs of inducing a recession go up significantly, so the relative disadvantages of monetary preemption over letting the bubble run its course mount. In the end, there is no monetary substitute for financial stability, and no market substitute for monetary ease during severe credit crunch. These two realities imply that the central bank should not take asset prices directly into account in monetary policymaking but should be anything but laissez-faire in responding to sharp movements in inflation and output, even if asset price swings are their source.
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Bibliographic InfoPaper provided by Peterson Institute for International Economics in its series Working Paper Series with number WP06-1.
Date of creation: Jan 2006
Date of revision:
bubbles; asset prices; monetary policy; central banks;
Other versions of this item:
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-02-12 (All new papers)
- NEP-CBA-2006-02-12 (Central Banking)
- NEP-FIN-2006-02-12 (Finance)
- NEP-FMK-2006-02-12 (Financial Markets)
- NEP-MAC-2006-02-12 (Macroeconomics)
- NEP-MON-2006-02-12 (Monetary Economics)
- NEP-PKE-2006-02-12 (Post Keynesian Economics)
- NEP-SEA-2006-02-12 (South East Asia)
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