Central bank intervention and financial bubbles

This paper develops a model to study the impact on asset prices arising from central bank intervention during bubble bursts. In particular, we explore how investors react to a policy whereby the central bank decreases interest rates to alleviate market crashes or significant price reversals. We show that the possibility of central bank intervention creates incentives for investors to inflate asset prices since larger bubbles lead to (i) higher capital gains in case of no bust and (ii) higher probability of intervention (i.e, losses being absorbed by central bank’s intervention) upon bubble burst episodes. Our model predicts that (i) bubbles should be smaller in more fragile economies (i.e., economies where bubbles are more likely to burst) and (ii) larger in those scenarios where it is less costly for the central bank to cut rates and/or assets are more liquid. Finally, we show that central bank policies of the type studied in the paper are welfare enhancing if the cost imposed on the economy from a decrease in rates is sufficiently low (e.g. during non-inflationary periods) which, in turn, provides scope for forward guidance.