Supply: a tale of two bubbles.

• Author: Calabria, Mark A.
• Position: Report

To the extent that monetary policy influences asset prices, it does so via the demand for assets, by changing the borrowing costs to purchase assets, or via supply, where movements in interest rates can make investment in assets look more or less attractive. Fiscal policy interventions can also contribute to bubbles by changing the cost of acquiring specific assets. Most discussions of asset bubbles, particularly those involving the role of monetary policy, focus on demand-side factors. This article examines the role of supply-side factors in the recent booms in the U.S. housing market and dot-com stocks. The importance of supply constraints in each market is discussed. Policy implications are then presented.

Why Supply Matters

If interest rates fall as a result of monetary policy, the demand and supply of assets whose purchase by consumers and production by producers is largely financed are likely to increase. Changes in interest rates can also alter the rate at which corporations and households discount future cash flows. While this simultaneous increase in both demand and supply will result in an increase in the equilibrium quantity, the impact on price is indeterminate.

When demand and supply increase in equal proportion, then quantity expands while price remains constant. One would rarely, if ever, characterize that situation as an asset bubble. Likewise, when supply increases more than in proportion to demand, the resulting decrease in price would not constitute an asset bubble.

Where both short-run and long-run supply are inelastic, a positive demand shock resulting from monetary policy is likely to permanently raise asset prices, in the absence of a following negative demand shock (which itself can be driven by monetary policy).

The remaining possibility is when demand increases more than in proportion to supply and there is an increase in both price and quantity. It is this possibility that policymakers need to be most concerned with, especially in the case where short-run supply is relatively inelastic and long-run supply is fairly elastic. Such circumstances can result in large increases in price until sufficient supply can be produced. Of crucial importance is the transition time required to move from the short-run to the long-rtm. The longer this transition time, the further short-run fundamentals can deviate from long-run equilibrium.

This article avoids the debate over whether bubbles actually occur or not. The assumption is made that price increases that deviate from trend and later display some decline in price, but do not appear related to observable fundamentals, can be characterized as bubbles or booms.

The Housing Bubble

Stanford economist John B. Taylor (2009) has presented the compelling counterfactual that ff monetary policy had followed a "Taylor Rule," housing starts would have been significantly below their actual level. For instance in 2006, at the height of the housing bubble, Taylor finds an excess of almost 600,000 housing starts--an almost 40 percent increase in supply, Yet, such a massive increase occurred in an environment of escalating house prices.

The observed increase in both housing starts and prices suggests that the increase in demand was significantly greater than the increase in supply, By October 2010, real housing prices were still above their pre-bubble level, despite large declines. Previous housing booms and busts have resembled more the case where new supply ultimately exceeds the increase in demand. The construction booms in the early and late 1980s, the mid-1960s, the late 1960s, and the early 1970s all ended with real housing prices falling below or near their pre-bubble lows. The housing...