Should Monetary Policy Target Asset Bubbles?
How do we define asset bubble?
In simple form, separate the price of an asset into two components, first is the underlying economic fundamentals and second is the non-fundamental bubble that may reflect price speculation or irrational investor euphoria or depression.
How bad bubbles are?
First we examine how asset prices influence inflation and aggregate economic activity. Asset bubbles can act through various channels to shift the Aggregate Demand Curve to the right:
1. Consumption - rising asset prices increase accumulated wealth and create wealth effect on households, also household’s positive expectation about future will boost their confidence to spend more.
2. Investment - asset prices provide signals regarding profitable investments. For example, higher equity prices driven by bubble-type factors like "irrational exuberance" create over-optimistic business forecast and boost business investment by lowering the cost of capital.
3. Government - asset price bubbles distort government financing decisions as well. As equity prices rise, tax revenues tied to capital gains go up. Government tends to spend more as revenue increase.
Without the support of fundamentals such as lower interest rates or faster productivity growth, the above factors will only shift the AD curve to the right and meet the SRAS curve at a higher price and higher output level, creating an “inflationary output gap”. In economic model, under the long run scenario, when the input resource prices have been fully adjusted to changes in the price level, the SRAS curve will shift up and the AD, SRAS and LRAS will meet again on a new equilibrium resuming the potential GDP but with a higher price than before, in the long run real variables are unchanged and the whole economy is not better off by any increase in production but is worst off by the leaving an inflation.
Apart from resulting misallocation of economic resources due to the wrong signal delivered, there are other
In simple form, separate the price of an asset into two components, first is the underlying economic fundamentals and second is the non-fundamental bubble that may reflect price speculation or irrational investor euphoria or depression.
How bad bubbles are?
First we examine how asset prices influence inflation and aggregate economic activity. Asset bubbles can act through various channels to shift the Aggregate Demand Curve to the right:
1. Consumption - rising asset prices increase accumulated wealth and create wealth effect on households, also household’s positive expectation about future will boost their confidence to spend more.
2. Investment - asset prices provide signals regarding profitable investments. For example, higher equity prices driven by bubble-type factors like "irrational exuberance" create over-optimistic business forecast and boost business investment by lowering the cost of capital.
3. Government - asset price bubbles distort government financing decisions as well. As equity prices rise, tax revenues tied to capital gains go up. Government tends to spend more as revenue increase.
Without the support of fundamentals such as lower interest rates or faster productivity growth, the above factors will only shift the AD curve to the right and meet the SRAS curve at a higher price and higher output level, creating an “inflationary output gap”. In economic model, under the long run scenario, when the input resource prices have been fully adjusted to changes in the price level, the SRAS curve will shift up and the AD, SRAS and LRAS will meet again on a new equilibrium resuming the potential GDP but with a higher price than before, in the long run real variables are unchanged and the whole economy is not better off by any increase in production but is worst off by the leaving an inflation.
Apart from resulting misallocation of economic resources due to the wrong signal delivered, there are other
References: [2] George Soros, (2008) The New Paradigm for Financial markets, the Credit Crisis of 2008 and What it Means, Public Affairs [3] Ben S. Bernanke, (2002) Asset-Price “Bubbles” and Monetary Policy. The Federal Reserve Board, Remarks by Governor Ben S. Bernanke, October 15, 2002 [Online] Available at: http://www.federalreserve.gov/boarddocs/speeches/2002/20021015/default.htm [4] David Gruen, Michael Plumb and Andrew Stone, (2003) How Should Monetary Policy Respond to Asset-price Bubbles? RESERVE BANK OF AUSTRALIA 2003 CONFERENCE [Online] Available at: http://www.rba.gov.au/PublicationsAndResearch/Conferences/2003/Gruen_Plumb_Stone.pdf [5] Donald L. Kohn, (2006) Monetary policy and asset prices. Speech at "Monetary Policy: A Journey from Theory to Practice," a European Central Bank Colloquium held in honor of Otmar Issing, Frankfurt, Germany March 16, 2006 [Online] Available at: http://www.federalreserve.gov/newsevents/speech/kohn20060316a.htm [6] Frederic S. Mishkin, (2008) How Should We Respond to Asset Price Bubbles? Speech at the Wharton Financial Institutions Center and Oliver Wyman Institute 's Annual Financial Risk Roundtable, Philadelphia, Pennsylvania, May 15, 2008 [Online] Available at: http://www.federalreserve.gov/newsevents/speech/mishkin20080515a.htm [7] Glenn D. Rudebusch, (2005) Monetary Policy and Asset Price Bubbles. FRBSF Economic Letter 2005-18; August 5, 2005 [Online] Available at: http://www.frbsf.org/publications/economics/letter/2005/el2005-18.html [8] Hans Genberg, (2008) Asset Prices and Central Bank Policy. Executive Director (Research) Hong Kong Monetary Authority at the Conference on "The ECB and its Watchers", Frankfurt, 5 September, 2008 [Online] Available at: http://www.info.gov.hk/hkma/eng/speeches/speechs/hans/20080905e1.htm [9] Lorenzo Bini Smaghi, (2009) Monetary policy and asset prices. European Central Bank, 14 October 2009 [Online] Available at: http://www.ecb.int/press/key/date/2009/html/sp091014.en.html [10] Stephen Cecchetti, (2005) How should Monetary Policy respond to Asset Price Bubbles? Börsen-Zeitung, February 1, 2005 [Online] Available at: http://www.brandeis.edu/global/news/newsarch/2005/stories/cecchetti_asset_bubbles_article_05.html [11] N. Gregory Mankiw, (1992) Macroeconomics, Third Edition, Worth Publishers