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Should Central Banks Burst Bubbles?

  • John Conlon

    (University of Mississippi)

Policy towards speculative bubbles is examined in a model of a finite horizon 'greater fool' bubble, with rational agents, asymmetric information and short-sales constraints. This model permits the use of standard tools of comparative dynamics and welfare economics to analyze bubble policies. Government policy is modeled as deflating overpriced assets by revealing information about whether or not the asset is overpriced. It is shown that such a policy tends to improve welfare if it protects less-informed buyers from 'bad' sellers, who know the asset is overpriced. However, if policy deflates prices only in 'strong bubbles,', where all private agents know the asset is overpriced, this tends to reduce welfare. This is because, in those states where the central bank turns out not to deflate prices, bad sellers become more confident of selling the asset. That is, bubble bursting protects bad sellers from each other, which, in turn, can exacerbate the lemons problem in states where the asset is valuable.

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Paper provided by EconWPA in its series Game Theory and Information with number 0508007.

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Length: 46 pages
Date of creation: 12 Aug 2005
Date of revision:
Handle: RePEc:wpa:wuwpga:0508007
Note: Type of Document - pdf; pages: 46
Contact details of provider: Web page: http://econwpa.repec.org

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