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Why Central Banks Should Not Burst Bubbles

  • Adam S. Posen

    ()

    (Institute for International Economics)

Central banks should not be in the business of trying to prick asset price bubbles. Bubbles generally arise out of some combination of irrational exuberance, technological jumps, and financial deregulation (with more of the second in equity price bubbles and more of the third in real estate booms). Accordingly, the connection between monetary conditions and the rise of bubbles is rather tenuous, and anything short of inducing a recession by tightening credit conditions prohibitively is unlikely to stem their rise. Even if a central bank were willing to take that one-in-three or less shot at cutting off a bubble, the cost-benefit analysis hardly justifies such preemptive action. The macroeconomic harm from a bubble bursting is generally a function of the financial system’s structure and stability—in modern economies with satisfactory bank supervision, the transmission of a negative shock from an asset price bust is relatively limited, as was seen in the United States in 2002. However, where financial fragility does exist, as in Japan in the 1990s, the costs of inducing a recession go up significantly, so the relative disadvantages of monetary preemption over letting the bubble run its course mount. In the end, there is no monetary substitute for financial stability, and no market substitute for monetary ease during severe credit crunch. These two realities imply that the central bank should not take asset prices directly into account in monetary policymaking but should be anything but laissez-faire in responding to sharp movements in inflation and output, even if asset price swings are their source.

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Paper provided by Peterson Institute for International Economics in its series Working Paper Series with number WP06-1.

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Date of creation: Jan 2006
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Handle: RePEc:iie:wpaper:wp06-1
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  1. Thomas F. Cargill & Michael M. Hutchison & Takatoshi Ito, 2001. "Financial Policy and Central Banking in Japan," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262032856, June.
  2. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
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  8. Marcus H. Miller & Paul Weller & Lei Zhang, 2002. "Moral Hazard and the US Stockmarket: Analyzing the "Greenspan Put"," Working Paper Series WP02-1, Peterson Institute for International Economics.
  9. Adam Posen, 2003. "It Takes More Than a Bubble to Become Japan," RBA Annual Conference Volume, in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy Reserve Bank of Australia.
  10. DeLong, J Bradford, 2002. "Macroeconomic Vulnerabilities in the Twenty-First Century Economy: A Preliminary Taxonomy," International Finance, Wiley Blackwell, vol. 5(2), pages 285-309, Summer.
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  12. Adam S. Posen, 1998. "Restoring Japan's Economic Growth," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 35, March.
  13. Olivier Jeanne & Michael D. Bordo, 2002. "Monetary Policy and Asset Prices; Does "Benign Neglect" Make Sense?," IMF Working Papers 02/225, International Monetary Fund.
  14. Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
  15. Ben S. Bernanke & Ilian Mihov, 1996. "What Does the Bundesbank Target?," NBER Working Papers 5764, National Bureau of Economic Research, Inc.
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