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Asset-price Bubbles and Monetary Policy

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  • Christopher Kent

    (Reserve Bank of Australia)

  • Philip Lowe

    (Reserve Bank of Australia)

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    Abstract

    In this paper we develop a theoretical framework that helps to analyse the role of monetary policy in responding to asset-price bubbles. A large and rapid fall in the nominal price of assets that form the basis of collateral for loans from financial intermediaries can have adverse effects on financial system stability. This asymmetric effect of asset price changes, by reducing the extent of intermediated finance, can reduce output below potential and keep inflation below the central bank’s target for extended periods. We demonstrate that there may be circumstances where monetary policy should be tightened in response to an emerging asset-price bubble, in order to burst the bubble before it becomes too large, even though this means that expected inflation is below target in the short run. Such a policy is optimal because it can help to avoid extreme longer-term effects of a larger asset-price bubble and its eventual collapse. In principle, the adverse effects of asset-price bubbles on financial system stability can be moderated through appropriate financial system regulation and supervision. Nevertheless, provided that the effects of asset-price bubbles on the economy are not entirely eliminated, a role for monetary policy may remain.

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    Bibliographic Info

    Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9709.

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    Date of creation: Dec 1997
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    Handle: RePEc:rba:rbardp:rdp9709

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    1. Gertler, Mark, 1992. "Financial Capacity and Output Fluctuations in an Economy with Multi-period Financial Relationships," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 455-72, July.
    2. Ben Bernanke & Mark Gertler, 1987. "Financial Fragility and Economic Performance," NBER Working Papers 2318, National Bureau of Economic Research, Inc.
    3. Olivier J. Blanchard, 1993. "Movements in the Equity Premium," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(2), pages 75-138.
    4. David Gruen & Jacqueline Dwyer, 1995. "Are Terms of Trade Rises Inflationary?," RBA Research Discussion Papers rdp9508, Reserve Bank of Australia.
    5. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
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