“Asset Bubbles and Monetary Policy” by Pengfei Wang
Hong Kong University of Science and Technology
Shanghai Jiao Tong University
We provide an infinite-horizon model of rational asset bubbles in a dynamic new Keynesian framework. Entrepreneurs are heterogeneous in investment efficiency and face credit constraints. They can trade land as an asset, which also serves as collateral when borrowing from banks with reserve requirements. Land commands a liquidity premium and a land bubble can emerge. Monetary policy can affect the conditions for the existence of a bubble, its steady-state size, and its dynamics including the initial size. The ‘leaning against the wind’ interest rate policy reduces bubble volatility, but it could also raise inflation volatility. Whether monetary policy should respond to asset bubbles depends on the particular interest rate rule adopted by the central bank and on the type of exogenous shocks hitting the economy.