Monetary Policy and Herd Behavior: Leaning Against Bubbles

58 Pages Posted: 22 Dec 2012

See all articles by Olivier Loisel

Olivier Loisel

CREST-ENSAE

Aude Pommeret

University of Lausanne

Franck Portier

University of Toulouse I - Groupe de Recherche en Economie Mathématique et Quantitative (GREMAQ); Centre for Economic Policy Research (CEPR)

Date Written: December 1, 2012

Abstract

We study the role of monetary policy when asset-price bubbles may form due to herd behavior in investment in an asset whose return is uncertain. To that aim, we build a simple general-equilibrium model whose agents are households, entrepreneurs, and a central bank. Entrepreneurs receive private signals about the productivity of the new technology and borrow from households to publicly invest in the old or the new technology. The three main results of the paper are that bubbles (informational cascades) can occur in this general equilibrium setting; that the central bank can detect them even though it has directly access to less information than the investors; and that the central bank can eliminate bubbles by manipulating the interest rate. Indeed, monetary policy, by affecting the investors' cost of resources, can make them invest in the new technology if and only if they receive an encouraging private signal about its productivity. In doing so, it makes their investment decision reveal their private signal, and therefore prevents herd behavior and the asset-price bubble. We also show that such a “leaning against the wind" monetary policy, contingent on the central bank's information set, may be preferable to laisser-faire, in terms of ex ante welfare

Keywords: monetary policy, asset prices, informational cascades, bubbles

JEL Classification: E52, E32

Suggested Citation

Loisel, Olivier and Pommeret, Aude and Portier, Franck, Monetary Policy and Herd Behavior: Leaning Against Bubbles (December 1, 2012). Banque de France Working Paper No. 412, Available at SSRN: https://ssrn.com/abstract=2192466 or http://dx.doi.org/10.2139/ssrn.2192466

Olivier Loisel (Contact Author)

CREST-ENSAE ( email )

5 avenue Henry Le Chatelier
Palaiseau, 91120
France

Aude Pommeret

University of Lausanne ( email )

Quartier Chambronne
Lausanne, Vaud CH-1015
Switzerland

Franck Portier

University of Toulouse I - Groupe de Recherche en Economie Mathématique et Quantitative (GREMAQ) ( email )

Manufacture des Tabacs
21 Allees de Brienne
Toulouse, 31000
France
+33 5 6112 8840 (Phone)
+33 5 6112 8637 (Fax)

HOME PAGE: http://fpj.portier.free.fr/home

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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