RDP 9709: Asset-price Bubbles and Monetary Policy 5. Conclusion

In this paper we have developed a theoretical framework that helps to analyse the role of monetary policy in responding to asset-price bubbles. Our primary concern is with asset classes that form the basis of collateral for loans from financial intermediaries, and thus have implications for the financial system. A large and rapid fall in the nominal price of these assets can have adverse effects on financial system stability. In this way the collapse of the bubble can reduce the extent of intermediated finance, reduce output below potential for an extended period and, in the process, keep inflation below the central bank's target.

The central insight of our analysis is that when an asset-price bubble emerges, there may be circumstances where monetary policy should be tightened in order to bring on the collapse of the bubble before it becomes too large, even though this means that expected inflation is (temporarily) below target. The reason for doing so is that such a policy can help to avoid extreme longer-term effects of a larger asset-price bubble and its eventual collapse. This result is driven by three essential elements. First, tighter monetary policy increases the likelihood of the bubble bursting. Second, when the bubble bursts it does not reappear for some time. And third, that the monetary authority wants to avoid the possibility of extreme outcomes for inflation.

Satisfying the requirements for good financial regulation should significantly reduce the costs of collapses in asset-price bubbles, and also help to slow the progress of a bubble by putting pressure on the circular linkages between asset prices, collateral values, intermediated finance and output. This should reduce (although not eliminate) the need for monetary policy to respond to asset-price bubbles, allowing expected inflation to be closer to target, and output to be closer to potential output. Finally, in a low-inflation environment asset-price bubbles are less likely, although if they occur, they may be more costly. An implication of this is that asset-price developments need to be carefully studied by central banks even when goods and services price inflation is at, or close to, target.