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Should Central Banks Burst Bubbles?

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  • John Conlon

    (University of Mississippi)

Abstract

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.

Suggested Citation

  • John Conlon, 2005. "Should Central Banks Burst Bubbles?," Game Theory and Information 0508007, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpga:0508007
    Note: Type of Document - pdf; pages: 46
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    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/game/papers/0508/0508007.pdf
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    References listed on IDEAS

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    Cited by:

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    2. Kai, Guo & Conlon, John R., 2007. "Why Bubble-Bursting Is Unpredictable: Welfare Effects Of Anti-Bubble Policy When Central Banks Make Mistakes," MPRA Paper 5927, University Library of Munich, Germany.

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    More about this item

    Keywords

    Bubbles; Asymmetric Information; Policy;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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