Should Central Banks Burst Bubbles? Risk Sharing and the Welfare Effects of Bubble Policy

Abstract

This paper investigates the welfare consequences of bubble policy in a greater-fool bubble model with rational, risk averse investors in an asset market. Some investors may be informed that the asset is overpriced, and try to sell to uninformed buyers. A central bank prevents speculative bubbles by revealing the state of the world to the entire market if at least one agent knows for sure that the asset is overpriced. We show that such a policy may be harmful for both buyers and sellers in asset markets, because the information revelation interferes with beneficial risk sharing between the agents, as in Hirshleifer (1971). This contrasts with previous results that show that anti-bubble policy can improve the allocation of production in asset markets. Therefore, this study suggests that asset market policy presents a trade-off between the allocation of production and the allocation of risk.

Keywords: Asset bubbles, Financial market policy, Macroeconomics

JEL Classification: D, E, G