RDP 2003-11: How Should Monetary Policy Respond to Asset-Price Bubbles? 4. Discussion and Conclusions

Table 1 provides a summary of the results. For each set of assumptions, it shows, as time proceeds and the bubble grows, whether the activist would recommend tighter (+), looser (−) or the same (=) policy settings as the sceptic.

There are several broad lessons worth highlighting from this summary. When the asset-price bubble is small enough, the activist policy-maker always (except in the case of the rational bubble) recommends tighter policy than the sceptic who ignores the future possible paths of the bubble. However, this result is of limited practical relevance. Although we have assumed that activist policy-makers learn about the nature of the bubble at its inception, in reality there is likely to be much doubt in the early stages about whether rising asset prices constitute a bubble. Asset-price bubbles rarely arise out of thin air – instead, they usually occur when the evolving economic fundamentals are consistent with some rise in asset prices. While there will always be some doubt about whether rising asset prices constitute a bubble, these doubts would seem particularly acute when the suspected deviation of asset prices from fundamentals remains small and has been short-lived. For these reasons, there would seem to be no strong case for central banks to respond to small asset-price misalignments.^[16]

As the bubble grows, however, there are two developments with potentially conflicting implications for appropriate activist policy. On the one hand, an activist policy-maker should become increasingly confident that the observed asset-price rises do constitute a bubble, which should strengthen the case for responding actively to them. On the other hand, as the bubble grows, the potential negative effects from its eventual bursting will increase. Whether this constitutes an argument for tighter or looser policy will depend on the nature of the bubble.

The case for tightening is to offset the expansionary effects of future expected growth of the bubble and, in some formulations, to reduce the bubble's growth or help to burst it. As we have seen, there are circumstances in which this case is particularly compelling, in particular when: the probability that the bubble will burst of its own accord over the next year is assessed to be small; the bubble's probability of bursting is quite interest sensitive; efficiency losses associated with the bubble rise strongly with the bubble's size; or, the bubble's demise is expected to occur gradually over an extended period, rather than in a sudden bust. Conversely, the case for loosening is strongest when these conditions are reversed, since in those circumstances it becomes increasingly important to allow for the contractionary impact that arises when the bubble bursts.^[17] The stochastic process driving the bubble is thus crucial to determining which of these considerations predominates.^[18]

Ultimately, the appropriate policy strategy is a matter for judgement. Since the optimal policy response at any point depends on the stochastic properties of the bubble, our results highlight the information requirements inherent in an activist approach. Where sufficient information about the bubble process is not available to the policy-maker, a robust approach, something along the lines of the one used by our sceptic, may be the best that can be achieved. Given sufficient information about the bubble process, an activist approach may be feasible, but our results suggest that the appropriate response to bubbles is not uniform. In particular, it may be optimal to ‘lean against’ some bubbles but not others, and hence the formulation of an activist strategy requires judgments to be made about the process driving the bubble and its likely sensitivity to monetary policy.