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Financial Fragility, Bubbles and Monetary Policy

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  • Gerhard Illing

Abstract

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 generates 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 reduces the real value of nominal debt and so gives rise to a ?put option? for investors, driving up asset prices above their fundamental value. The paper shows that the size of such a bubble is likely to be rather small. The bubble is only equal to the expected value of capital gains on outstanding debt, which are fairly limited in a crisis. Since, in contrast, the gains from preventing the disruption of financial intermediation can be quite large, it is rational for a central bank to inject liquidity in a crisis.

Suggested Citation

  • Gerhard Illing, 2001. "Financial Fragility, Bubbles and Monetary Policy," CESifo Working Paper Series 449, CESifo.
    • Handle: RePEc:ces:ceswps:_449
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    References listed on IDEAS

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    1. Cecchetti, Stephen G. & Kashyap, Anil K, 1996. "International cycles," European Economic Review, Elsevier, vol. 40(2), pages 331-360, February.
    2. Timothy Cogley, 1999. "Should the Fed take deliberate steps to deflate asset price bubbles?," Economic Review, Federal Reserve Bank of San Francisco, pages 42-52.
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    Cited by:

    1. Helmut Wagner & Wolfram Berger, 2004. "Globalization, Financial Volatility and Monetary Policy," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 31(2), pages 163-184, June.
    2. Gunther Schnabl & Andreas Hoffmann, 2008. "Monetary Policy, Vagabonding Liquidity and Bursting Bubbles in New and Emerging Markets: An Overinvestment View," The World Economy, Wiley Blackwell, vol. 31(9), pages 1226-1252, September.
    3. Eric Tymoigne, 2006. "Asset Prices, Financial Fragility, and Central Banking," Economics Working Paper Archive wp_456, Levy Economics Institute.
    4. Grégory Levieuge, 2005. "Politique monétaire et prix d'actifs," Revue de l'OFCE, Presses de Sciences-Po, vol. 93(2), pages 317-355.
    5. Entela Myftari & Sergio Rossi, 2010. "Prix des actifs et politique monétaire : enjeux et perspectives après la crise financière de 2007-2009," L'Actualité Economique, Société Canadienne de Science Economique, vol. 86(3), pages 355-383.
    6. Gerhard Illing & Ulrich Klüh, 2005. "Vermögenspreise und Konsum: Neue Erkenntnisse, amerikanische Erfahrungen und europäische Herausforderungen," Perspektiven der Wirtschaftspolitik, Verein für Socialpolitik, vol. 6(1), pages 1-22, February.
    7. Albulescu, Claudiu Tiberiu, 2008. "Central banks and asset prices: the role of the interest rate in volatility correction in the Romanian case," MPRA Paper 16582, University Library of Munich, Germany, revised 20 Jul 2009.
    8. Zhou, Ge, 2011. "Rational bubbles and the spirit of capitalism," MPRA Paper 33988, University Library of Munich, Germany.
    9. Wong, Chin-Yoong & Eng, Yoke-Kee, 2012. "Asset price boom–burst cycle as an elastic money response to technological shocks," Economics Letters, Elsevier, vol. 114(3), pages 292-295.

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