The issue is whether monetary policy should try to pop

February 28, 2019 General Studies

The issue is whether monetary policy should try to pop, or slow, the growth of possibly developing asset price bubbles to minimize damage to the economy when these bubbles burst. Two Types of Asset-Price Bubbles There are two types of asset-price bubbles: one that is forced by credit and a second that is forced entirely by optimistic expectations credit driven bubbles. When a credit boom begins, it can drain into an asset price bubble: Easier credit can be used to purchase particular assets and thereby raise their prices. The policy instrument is a variable that responds to the central bank’s tools and indicates the stance (easy or tight) of monetary policy. A central bank must be able to test effective control over a variable if it is to function as a useful policy instrument. Monetary policy actions are a very round instrument in such a case, as such actions would be likely to affect asset prices in general, rather than the specific assets that are experiencing a bubble. As long as monetary policy responds timely, by easing monetary policy aggressively after an asset bubble bursts, the harmful effects of a bursting bubble could be kept at a manageable level. A rapid rise in asset prices lead by a credit boom provides a signal that market failures or poor financial regulation and supervision might be causing a bubble to form. Strategy: Central banks directly control the conventional tools of monetary policy open market operations, discount rate, reserve requirements, and interest rate on reserves but knowing the tools and the strategies for implementing a monetary policy does not tell us whether policy is easy or tight. Conclusion Monetary policy should react to asset price bubbles by looking to the effects of asset prices on employment and inflation, then adjusting policy as required to achieve maximum sustainable employment and price stability. Asset price bubbles that are link with credit booms present particular challenges, because their bursting can lead to event of financial instability that have damaging effects on the economy. Monetary policy should not try to cut possible asset price bubbles, even when they are of the variety that can contribute to financial instability.

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