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On Interest Rate Policy and Asset Bubbles

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  • Franklin Allen
  • Gadi Barlevy
  • Douglas Gale

Abstract

In a provocative paper, Gal (2014) showed that a policymaker who raises interest rates to rein in a potential bubble will only make a bubble bigger if one exists. This poses a challenge to advocates of lean-against-the-wind policies that call for raising interest rates to mitigate potential bubbles. In this paper, we argue there are situations in which the lean-against-the wind view is justified. First, we argue Gal?s framework abstracts from the possibility that a policymaker who raises rates will crowd out resources that would have otherwise been spent on the bubble. Once we modify Gal?s model to allow for this possibility, policymakers can intervene in ways that raise interest rates and dampen bubbles. However, there is no reason policymakers should intervene to dampen the bubble in this case, since the bubble that arises in Gal?s setup is not one that society would be better off without. We then further modify Gal?s model to generate the type of credit-driven bubbles that alarm policymakers, and argue there may be justification for intervention in that case.

Suggested Citation

  • Franklin Allen & Gadi Barlevy & Douglas Gale, 2017. "On Interest Rate Policy and Asset Bubbles," Working Paper Series WP-2017-16, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhwp:wp-2017-16
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    References listed on IDEAS

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    1. Ricardo J. Caballero & Emmanuel Farhi & Mohamad L. Hammour, 2006. "Speculative Growth: Hints from the U.S. Economy," American Economic Review, American Economic Association, vol. 96(4), pages 1159-1192, September.
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    4. Frederic S. Mishkin, 2011. "Monetary Policy Strategy: Lessons from the Crisis," NBER Working Papers 16755, National Bureau of Economic Research, Inc.
    5. Tomohiro Hirano & Noriyuki Yanagawa, 2017. "Asset Bubbles, Endogenous Growth, and Financial Frictions," Review of Economic Studies, Oxford University Press, vol. 84(1), pages 406-443.
    6. Waldo, Douglas G, 1985. "Open Market Operations in an Overlapping Generations Model," Journal of Political Economy, University of Chicago Press, vol. 93(6), pages 1242-1257, December.
    7. Jordi Gal?, 2014. "Monetary Policy and Rational Asset Price Bubbles," American Economic Review, American Economic Association, vol. 104(3), pages 721-752, March.
    8. Klaus Adam, 2003. "Learning and Equilibrium Selection in a Monetary Overlapping Generations Model with Sticky Prices," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 887-907.
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    Cited by:

    1. Alberto Martin & Jaume Ventura, 2018. "The Macroeconomics of Rational Bubbles: A User's Guide," Annual Review of Economics, Annual Reviews, vol. 10(1), pages 505-539, August.
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    3. Ting Lan, 2019. "Intrinsic bubbles and Granger causality in the Hong Kong residential property market," Frontiers of Business Research in China, Springer, vol. 13(1), pages 1-15, December.
    4. Alexey Vasilenko, 2018. "Should Central Banks Prick Asset Price Bubbles? An Analysis Based on a Financial Accelerator Model with an Agent-Based Financial Market," Bank of Russia Working Paper Series wps35, Bank of Russia.

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    More about this item

    Keywords

    Interest rate; monetary policy; asset bubble;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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