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How Should Monetary Policy Respond to Asset-price Bubbles?

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  • David Gruen

    (Australian Treasury)

  • Michael Plumb

    (Reserve Bank of Australia)

  • Andrew Stone

    (Reserve Bank of Australia)

Abstract

We present a simple model of the macroeconomy that includes a role for an asset-price bubble, and derive optimal monetary policy settings for two policy-makers. The first policy-maker, a sceptic, does not attempt to forecast the future possible paths for the asset-price bubble when setting policy. The second policy-maker, an activist, takes into account the complete stochastic implications of the bubble when setting policy. We examine the optimal policy recommendations of these two policy-makers across a range of plausible assumptions about the bubble. We show that the optimal monetary policy recommendations of the activist depend on the detailed stochastic properties of the bubble. There are some circumstances in which the activist clearly recommends tighter policy than that of the sceptic, while in other cases, the appropriate recommendation is to be looser than the sceptic. Other things equal, the case for ‘leaning against’ a bubble with monetary policy is stronger the lower the probability of the bubble bursting of its own accord, the larger the efficiency losses associated with big bubbles, and the higher the assumed impact of monetary policy on the bubble process.

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Bibliographic Info

Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp2003-11.

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Date of creation: Nov 2003
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Handle: RePEc:rba:rbardp:rdp2003-11

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Keywords: optimal monetary policy; asset-price bubble;

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  1. Laurence Ball, 1993. "What determines the sacrifice ratio?," Working Papers 93-21, Federal Reserve Bank of Philadelphia.
  2. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
  3. Glenn Rudebusch, 1995. "What are the lags in monetary policy?," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue Feb 3.
  4. Ben Bernanke & Mark Gertler, 2000. "Monetary Policy and Asset Price Volatility," NBER Working Papers 7559, National Bureau of Economic Research, Inc.
  5. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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