Asset Price Bubbles and Macroeconomic Policy

An important question that the experience of the Global Financial Crisis has brought to the fore is how the macro policy authorities should respond to asset price bubbles. In this paper, we first review the pros and cons of using macroeconomic policy for preventing or stopping bubbles. It concludes that, given our limited understanding of the bubble phenomenon, it is difficult to justify the use of standard macroeconomic policy (monetary and fiscal policy) tools for this purpose. However, it does not mean that the policy authorities have nothing to do but to sit and let the bubble grow, and do their best to contain adverse effects on the economy after its burst. What they can do instead is to analyze asset prices, assess their levels, and send warning signals to the market when the presence of a bubble is suspected, thereby encouraging an early correction of market prices. This is a major deviation from the authorities' traditional stance that they refrain from commenting on the level of asset prices, leaving their determination entirely to the market. However, such a shift of stance seems inevitable in light of the huge economic costs that have been caused by the bubble episode over the past several years.