Teaching macroeconomics: Monetary policy and asset bubbles

Economist’s View has a quick summary of a relevant paper by Jordi Galí on monetary policy and rational asset price bubbles:

What’s the key mechanism working against the traditional “lean against the wind” policy? That rational bubbles grow at the rate of interest, hence raising real interest rates makes the bubble grow faster. From the introduction [of the paper by Galí]:

…The role that monetary policy should play in containing … bubbles has been the subject of a heated debate, well before the start of the recent crisis. The consensus view among most policy makers in the pre-crisis years was that central banks should focus on controlling inflation and stabilizing the output gap, and thus ignore asset price developments, unless the latter are seen as a threat to price or output stability. Asset price bubbles, it was argued, are difficult if not outright impossible to identify or measure; and even if they could be observed, the interest rate would be too blunt an instrument to deal with them, for any significant adjustment in the latter aimed at containing the bubble may cause serious “collateral damage” in the form of lower prices for assets not affected by the bubble, and a greater risk of an economic downturn.

via Economist’s View: Jordi Galí: Monetary Policy and Rational Asset Price Bubbles.

About mkevane

Economist at Santa Clara University and Director of Friends of African Village Libraries.
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