How Important Should Bubbles Be In The Conduct of Monetary Policy? By Andrew Filardo, BIS Prepared for the 10 th Dubrovnik Economic Conference 24 June 2004

Renewed Interest in Research Debate Don’t React Bernanke and Gertler (1999) (5-period bubble, realistic policy rules) React but worry about ability to identify bubbles Cecchetti, Genberg, Lipsky and Wadhwani (2000) (Wider range of policy rules-still not optimal) Linearized solution methods raise important questions about the nature of bubbles being studied

Key Contributions of the Paper Methodology – simple macro model with a more “satisfying” bubble specification versus more complex macro model Modeling – endogenous bubbles in a dynamic macro model Pricking, not just reacting to, bubbles?

A Fork in the Research Road!

Preview of Findings It is optimal to respond to asset prices generally and bubbles specifically! Volatility of asset prices is not key – it is paradigm uncertainty about the role of asset prices in the macroeconomy that matters For our purposes, an asset price bubble is an asset price generally considered to be out of line with economic fundamentals = macroeconomic asset price bubbles.

Monetary Policy and Asset Prices Asset price booms & busts have been extreme developments that monetary authorities have had to face. US Nasdaq and S&P 500

Monetary Policy and Asset Prices Asset price booms and busts are an important feature of the monetary policy landscape going forward. [Borio, English and Filardo (2003)] Asset price booms and busts have been extreme developments that monetary authorities have had to face.

Monetary Policy and Asset Prices

Recent Policy Maker Statements: Greenspan, Bubbles and Policy “[T]he endeavors of policy makers to stabilize our economies require a functioning model of the way our economies work. Increasingly, it appears that this model needs to embody movements in equity premiums and the development of bubbles if it is to explain history.” Jackson Hole 2002

A European Perspective “The problem of how to design monetary policy … [to deal with asset prices and bubbles] … is probably the biggest challenge for central banks in our time.” O. Issing Wall Street Journal “Should Central Banks Burst Bubbles?” 18 February 2004

Small-scale Macro Model

Asset Price Block

Monetary Policy subject to the model of the macroeconomy and asset prices:

Monetary Policy Linear Class of Reaction Functions Solved using simulation methods

Modeling the Bubble Time-Varying Transition Probability Model

Modeling the Bubble Time-Varying Transition Probability Model

A “Macroeconomic Asset Price Bubble” Time-Varying Transition Probability Model Sample Path of a Bubble - “Blowing Bubbles” Time periods

Modeling the Bubble No-Bubble State Transition Probability Function of y t-1

Modeling the Bubble Bubble State Transition Probability P 1,1

Alternative Policy Specifications No response to asset prices (simple Taylor rule) Response to overall asset prices Differential response to asset price components

Basic Results: Pricking AP Is Optimal Optimal Policy Parameters

Results for Optimal Policy Variance of inflation Variance of output Optimal Monetary Policy Frontiers

Results for Optimal Policy Variance of inflation Variance of output Optimal Monetary Policy Frontiers Superior policy

Results for Optimal Policy Variance of inflation Variance of output Optimal Monetary Policy Frontiers

Basic Results: Pricking AP Is Optimal Optimal Policy Frontiers No response to AP

Basic Results: Pricking AP Is Optimal Optimal Policy Frontiers No response to AP Response to AP

Basic Results: Pricking AP Is Optimal Optimal Policy Frontiers No response to AP Response to AP Response to F and B

Two Key Results 1. Responding to asset prices is generally welfare enhancing in this class of models 2. Being able to distinguish bubbles from fundamental asset price movements is of second order importance

Bottom Line for Monetary Policy It is generally optimal for a monetary authority to respond to asset price movements:  1. tightening during asset price booms  2. easing during the collapse phase.

Nonlinear Impulse Responses Two Types Gallant, Tauchen and Rossi (1993) Koop, Pesaran and Potter (1996)

Nonlinear Impulse Responses Output

Nonlinear Impulse Responses Endogenous bubble models admit richer dynamics Chaotic behavior is possible Monetary policy helps to stabilize the economy… Not only by pricking bubbles but also by opportunistically exploiting bubbles

Pro-active Monetary Policy Strategies Defensive strategies – preventing and pricking asset price bubbles Opportunistic strategies – use bubbles to achieve stabilization goals

Expected Durations Negative bubble state Positive bubble state

Other Modeling Considerations Fiscal/prudential policies and monetary policy – What does the monetary authority do if fiscal and prudential authorities don’t do enough? Complications arising from the zero lower bound for nominal interest rates

Other Modeling Considerations Financial stability Increasingly recognized that price stability and financial stability need not be at odds! Convert into output and inflation costs – augment the loss function.

Modeling Extensions Insurance motives – Does it make sense to insure against low probability events? Inflation targeting frameworks and the optimal policy horizon Moral hazard – Does monetary policy stabilization implicitly grant a free put option to investors? Spillovers – Does the aggressive response to one bubble sow the seeds of other bubbles?

Paradigm Uncertainty Policy uncertainty – How can we calibrate the policy response given the inherent uncertainty about whether asset price bubbles truly matter? Compare the expected gains and losses from reacting to asset prices

Paradigm Uncertainty

Conclusions The case for focusing on asset price bubbles – it is a strong case. Monetary authorities should put emphasis on asset price bubbles in the formulation of policy. Moreover, it might be appropriate to prick bubbles… … if, and these are big ifs, - macroeconomic bubbles are deemed important - the role of these asset price movements on the macroeconomy is well understood

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