Rethinking Monetary Stabilization in the Presence of an Asset Bubble

Abstract

This paper addresses three important questions: how should monetary policy respond to stock market booms, what causes stock market bubbles and can monetary policy pop them. These questions arose during the recent stock market bubble during 1995-2000 and its collapse during 2000-1. To answer these questions we rapidly review the lessons learned from the Fed's response to the stock market boom in the 1920s and the lessons learned from the response of the Bank of Japan in the 1990s. The conclusion of the paper is that an asymmetric response of monetary policy to the stock market booms is appropriate: neutral in stock market booms unless they cause inflation, monetary ease after a stock market bust to dampen the effect on output and if necessary to provide liquidity to the financial system. The theoretical bubble literature and the U.S. experience in the 1920s provides little evidence that monetary policy can pop bubbles and attempting do so is potentially costly in terms of lost output.

Keywords: Rethinking, monetary, stabilization, asset, bubble