On Interest Rate Policy and Asset Bubbles

52 Pages Posted: 19 Sep 2017 Last revised: 25 May 2018

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Gadi Barlevy

Federal Reserve Bank of Chicago; National Bureau of Economic Research (NBER); IZA Institute of Labor Economics

Douglas M. Gale

New York University (NYU) - Department of Economics

Date Written: 2017-09-17

Abstract

In a provocative paper, Galí (2014) showed that a policymaker who raises interest rates to rein in a potential bubble will only make a bubble bigger if one exists. This poses a challenge to advocates of lean-against-the-wind policies that call for raising interest rates to mitigate potential bubbles. In this paper, we argue there are situations in which the lean-against-the wind view is justified. First, we argue Galí’s framework abstracts from the possibility that a policymaker who raises rates will crowd out resources that would have otherwise been spent on the bubble. Once we modify Galí’s model to allow for this possibility, policymakers can intervene in ways that raise interest rates and dampen bubbles. However, there is no reason policymakers should intervene to dampen the bubble in this case, since the bubble that arises in Galí’s setup is not one that society would be better off without. We then further modify Galí’s model to generate the type of credit-driven bubbles that alarm policymakers, and argue there may be justification for intervention in that case.

Keywords: Interest rate, monetary policy, asset bubble

JEL Classification: E43, E52

Suggested Citation

Allen, Franklin and Barlevy, Gadi and Gale, Douglas M., On Interest Rate Policy and Asset Bubbles (2017-09-17). FRB of Chicago Working Paper No. WP-2017-16. Available at SSRN: https://ssrn.com/abstract=3038779

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Gadi Barlevy

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Douglas M. Gale

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

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