Monetary Policy, Inflation, and Rational Asset Price Bubbles

• Published date: 01 September 2022
• Author: DAISUKE IKEDA
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/jmcb.12880

DOI: 10.1111/jmcb.12880

DAISUKE IKEDA

Monetary Policy, Ination, and Rational Asset Price

Bubbles

Ination has tended to be moderate during stock market booms in many

countries. Toexplain the pattern and study optimal monetary policy in such

a situation, this paper develops a dynamic model with rational bubbles

and nominal rigidities. The model features a nancial cost channel through

which the shadow cost of borrowing affects marginal costs. A bubble-led

boom mitigates rms’ borrowing constraints and keeps ination from rising

by decreasing the shadow cost. In this situation, Ramsey-optimal monetary

policy calls for tightening to curb the boom. Strict inationtargeting is coun-

terproductive in the shortr unas it exacerbates the boom. For obtaining these

results, the nancial cost channel and nominal wage rigidity are essential.

JEL codes: E44, E52

Keywords: asset price bubbles, nancial cost channel, optimal monetary

policy

I     circles a heated debate has

taken place over how monetary policyshould react to asset price booms or “bubbles.”

One inuential view among policymakers prior to the global nancial crisis of 2007–

08 was that monetary policy should focus on ination stabilization in a regime of

exible ination targeting.1Another view was that monetary policy should respond

This paper is based on Ikeda (2013), which was substantially revised during my secondment at the

Bank of England from July 2016 to July 2018. I am grateful to Takeshi Kimura for his support and com-

ments. I appreciate comments from and discussions with Kosuke Aoki, Francesco Bianchi, Stephen G.

Cecchetti, Martin Ellison, Andrea Ferrero, Jordi Gali, TomohiroHirano, Ryo Jinnai, Takashi Kano, Alberto

Martin, Riccardo M. Masolo, Toan Phan, Masashi Saito, Martin Schneider,Yuta Takahashi, Konstantinos

Theodoridis, Jaume Ventura, colleagues at the Bank of Japan and the Bank of England, and participants

of the International Conference on Macroeconomic Modeling in Times of Crisis at the Banque de France,

the 5th GRIPS International Conference of Macroeconomics and Policy, 2017 Royal Economic Society

Annual Conference, Barcelona GSE Summer Forum 2017, European Econometric Society Meeting 2017,

Day-Ahead Conference of the European System of Central Banks, and seminars at the Bank of Japan,

University of Tokyo,the Bank of England, University of Oxford, and Hitotsubashi University. The views

expressed in this paper are those of the author and should not be interpreted as the ofcial views of the

Bank of Japan.

D Iis with the Bank of Japan (E-mail: daisuke.ikeda@boj.or.jp).

1. See Bernanke and Gertler (1999, 2001), Bernanke (2002), and Kohn (2006) for this view

Journal of Money, Credit and Banking, Vol. 54, No. 6 (September 2022)

© 2021 The Ohio State University.

1570 :MONEY,CREDIT AND BANKING

to nancial conditions in some circumstances.2Views on the issue have been evolv-

ing following the nancial crisis, and despite their substantial differences, several

policymakers appear to agree that they should remain open to using monetary policy

as a supplementary tool to address nancial imbalances.3

These developments aside, the advancement of the literature on monetary policy in

asset price bubbles lags far behind the literature on rational bubbles, which has grown

rapidly following the nancial crisis.4In particular, monetary policyanalyses in asset

price bubbles in a New Keynesian framework—a standard workhorse of monetary

policy analyses for many central banks—remain scarce.

Thus motivated, this paper studies monetary policy in a New Keynesian model

with rational asset price bubbles. To this end, it rst revisits the empirical evidence,

reported by Bordo and Wheelock (2007) and Christiano et al. (2010), that ination

tends to be moderate during stock market booms.5This observation is important be-

cause it implies a trade-off between stabilizing ination and stabilizing the real econ-

omy during such booms. Next, to explain such a pattern, this paper embeds a rational

bubble model developed by Miao, Wang, and Xu (2015) and Miao and Wang (2018)

into a monetary business cycle model à la Christiano, Eichenbaum, and Evans (2005).

In the model a bubble emerges in the stock market value of rms through a feedback

loop mechanism supported by self-fullling beliefs. A bubble boosts the stock market

value of rms, increases their capacity to borrow,and stimulates the economic activ-

ity.

In the model, a bubble has both inationary and deationary effects. Inationary

pressure of a bubble arises from a well-known aggregate demand effect. A bubble

increases the stock market value of rms, stimulates employment and production, and

puts upward pressure on unit labor costs and thereby ination. Deationary pressure

has to do with the shadow cost of borrowing. A bubble mitigates rms’ borrowing

constraints, lowers the shadow cost, and adds downward pressure on marginal costs

and thereby ination. Indeed, in the log-linearized Phillips curve, the shadow cost of

borrowing emerges endogenously as a cost push shock.

This paper calls this latter channel through which a bubble affects ination as the

nancial cost channel. As a result of the deationary effect through the nancial cost

2. See Cecchetti et al. (2000), Borio and Lowe (2002), and White (2009) for this view.See also Trichet

(2005) for a view that emphasizes a role of monetary and credit developmentsin monetary policy conduct.

3. See Carney (2009), Bernanke (2010), King (2012), Shirakawa (2012), and Poloz (2015). Fora view

for and against using monetary policy to address nancial imbalances, see Borio (2014) and Svensson

(2011), respectively.

4. See, for example, Farhiand Tirole (2012), Martin and Ventura (2012), Doblas-Madrid (2012), Miao,

Wang, and Xu (2015), Aoki and Nikolov (2015), and Hirano, Inaba, and Yanagawa (2015) for the recent

literature on rational bubbles. For comprehensivesurveys of the literature, see Barlevy (2007, 2015), Miao

(2014), and Martin and Ventura(2018).

5. One of the most notable episodes of low ination during stock market booms is Japan’sasset price

bubble period of thelate 1980s. See, for example, Yamaguchi (1999) and Okina, Shirakawa, and Shiratsuka

(2001).

DAISUKE IKEDA :1571

channel in addition to the inationary effect through the aggregate demand channel,

ination remains moderate during asset price bubbles. And this is consistent with

the facts, presented in this paper, about stock market booms in many countries. The

presence of the nancial cost channel distinguishes the model from others including

rational bubble business cycle models of Miao, Wang, and Xu (2015) and Dong,

Miao, and Wang (2020).

The model is calibrated to and estimated for the U.S. economy. The estimation

shows that the model with the nancial cost channel ts the data better than the model

without such a channel. In particular, while the model with the nancial cost channel

successfully replicates the empirically observed negative correlations between the

cyclical components of the stock price index and the price level, the model without

it fails to do so; rather it generates positive correlations between such components.

Then, the model with the nancial cost channel is used for studying optimal

monetary policy. Specically, the paper studies Ramsey-optimal monetary policy—

optimal policy from a timeless perspective (Woodford 2003)—and various monetary

policy rules in a bubble equilibrium where an exogenous shock, called as a sentiment

shock, drives changes in the size of a bubble around steady state.

There are four ndings. First, in response to a bubble-led boom driven by a positive

sentiment shock, Ramsey-optimal monetary policy calls for monetary tightening in

the short run to curb the boom more than what would be warranted by ination sta-

bilization. Interestingly, the Ramsey policy barely affects the size of a bubble. This

feature implies that inefciencies that can be addressed by monetary policy are rooted

not in a bubble itself but in how the real economy responds to a bubble. Monetary

policy – a blunt tool that affects the economy broadly—can improve social welfare

by restraining volatile responses of the real economy to a bubble.

Second, strict ination targeting, which stabilizes ination completely,exacerbates

an excessive bubble-led boom in the short run, although it contributes to curbing the

boom in the long run. Stabilizing ination requires stabilizing the marginal cost. Be-

cause deationary pressure through the nancial cost channel dominates inationary

pressure through the aggregate demand effect in the short run, strict ination target-

ing calls for monetary easing at the onset of the boom. Such monetary easing fuels

the heated economy, making the excessive boom even more excessive in the short

run, and thereby induces a substantial welfare loss. In short, the divine coincidence

(Blanchard and Gali 2007) does not hold in the bubble-led boom.

Third, a monetary policy rule that responds strongly to nominal output performs the

best among various rules, achieving an outcome closest to that of the Ramsey policy.

If a monetary policy rule responds strongly only to output instead, it entails severe

monetary tightening and worsens welfare as ination falls sharply. Adding a strong

response to ination to this rule mitigates such severe tightening and generates an

appropriate level of tightening. Also, a monetary policy rule that responds to a bubble

performs poorly and could worsen welfare. This is a logical consequence of the rst

nding that a bubble itself is not a cause of inefciencies that can be addressed by

monetary policy.