Modelling ‘Leaning Against the Wind’ of Asset Price Bubbles

Abstract

This paper investigates the effects of different monetary policy regimes on asset prices. A model which incorporates speculative behaviour, central bank reactions and expectations of those reactions, is exposed to a series of shocks under two different regimes. The results of these simulations suggest that a policymaker who reacts (in a context of imperfect information) to possible bubble developments can deliver better economic outcomes, in terms of the level and volatility of the bubble, output and inflation, than a policymaker who does not react to asset prices. This area is of particular importance to policymakers since Goodhart and Hofmann (2008) argue that shocks to house prices, credit and money can have significant effects on the economy and overall price inflation. They find in particular that shocks to money and credit have a stronger effect on house prices when they are booming than at other times. As a result, they suggest that there may be a role for the central bank to play in responding indirectly to asset-price bubbles.