Asset Bubbles and Monetary Policy in Open Economies

Abstract

We develop a framework to analyze the role of asset prices in shaping monetary policy in open economies. Our model incorporates rational bubbles that provide a liquidity premium for firms facing borrowing constraints and uninsurable idiosyncratic shocks to investment efficiency. The dynamics of bubble prices influence aggregate investment efficiency by affecting capital allocation across heterogeneous firms. Under foreign interest rate shocks, bubble price dynamics have a significantly larger impact on aggregate outcomes compared to domestic productivity shocks. Welfare analysis reveals that an optimal "leaning-against-the-wind" policy yields substantial welfare improvements.

Keywords: Asset Bubbles, Open Economies, Optimal Monetary Policy

JEL Classification: E32, E44, E52, F41