Asset Price Support Policy During Crises: How Aggressive Should it Be?

Should a Central Bank (CB) aim at smoothing out all asset price volatility in crisis times? We consider an economy where leverage is endogenously determined by the CB asset price support policy during crises. By keeping the price of distressed assets above a critical level, the CB can induce a high-leverage equilibrium with high output but with infrequent financial crises. The optimal CB policy depends on whether the interventions necessary to support the high-leverage equilibrium are costly or not. If the CB does not require any net wealth to credibly promise the minimal intervention that will keep asset prices above the critical level, it is optimal to commit all its wealth to intervention. In contrast, if interventions are costly, there is a trade-off between enjoying higher leverage and output now, but withstanding a lower number of crises before falling into a low-leverage low-output trap, and a more prudent policy that can keep the economy longer in the high-leverage equilibrium. We find that more prudent policies tend to be optimal when leverage is more socially valuable or the Central Bank has more wealth.