Should Central Banks Prick Asset Price Bubbles? An Analysis Based on a Financial Accelerator Model with an Agent-Based Financial Market

Abstract

This paper studies whether and how the central bank should prick asset price bubbles, if the effect of interest rate policy on bubbles can significantly vary across periods. For this purpose, I first construct a financial accelerator model with an agent-based financial market that can endogenously generate bubbles and account for their impact on the real sector of the economy. Then, I calculate the effect of different nonlinear interest rate rules for pricking asset price bubbles on social welfare and financial stability. The results demonstrate that pricking asset price bubbles can enhance social welfare and reduce the volatility of output and inflation, especially if asset price bubbles are caused by credit expansion. Pricking bubbles is also desirable when the central bank can additionally implement an effective communication policy to prick bubbles, for example, effective verbal interventions aimed at the expectations of agents in the financial market.

Keywords: monetary policy; asset price bubble; New Keynesian macroeconomics; agent-based financial market

JEL Classification: E44, E52, E58, G01, G02