Asset Price Bubbles and Monetary Policy
Positive and negative asset price bubbles and their relationship to monetary policy are considered. Positive bubbles occur when there is an agency problem between banks and the people they lend money to because the banks cannot observe how the funds are invested. This causes a risk shifting problem and asset prices are bid up above their fundamental. The greater is uncertainty concerning monetary policy and the amount of aggregate credit the greater is the bubble. Negative bubbles can occur when there is a banking crisis that forces banks to simultaneously liquidate assets. Asset prices fall below their fundamental because of a lack of liquidity. If the central bank provides a monetary injection this negative bubble can be prevented.
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