Financial Fragility, Bubbles and Monetary Policy

The paper models the links between financial fragility, asset markets and monetary policy. It is shown that central bank’s concern about the cost of financial disruption may generate an asymmetric response, thus contributing to the creation of an asset price bubble. In an economy with a highly leveraged financial structure, the central bank has an incentive to prevent a “run” on financial intermediation by injecting liquidity when asset values fall significantly. The inflationary side effect of this policy, reducing the real value of nominal debt, is what gives rise to a “put option” for investors. Leveraged investors, rationally anticipating this liquidity injection, drive asset prices above their fundamental values. The bubble will be equal to the expected value of capital gains on outstanding debt. The paper shows that it is rational for central banks to inject liquidity in a crisis, whenever there is the risk of spillover effects arising from the disruption of financial intermediation.