How Important Should Bubbles Be In The Conduct of Monetary Policy? By Andrew Filardo, BIS Prepared...

How Important Should Bubbles Be In The Conduct of Monetary Policy?

By Andrew Filardo, BISPrepared for the 10th 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 PricesAsset 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. IssingWall Street Journal

“Should Central Banks Burst Bubbles?”18 February 2004

Small-scale Macro Model

ttBttt

tttAPttt

yPC

yryIS

1,11

11,11

)(

)()(

Asset Price Block

tty

ttFF

11,)(

1,

1,)(

tr

tyttB

B

Monetary Policy

)1

var()var()var(},,,{ rrryL

Ba

Faaya

Min

subject to the model of the macroeconomy and asset prices:

tBEt

AXtX 1

Monetary Policy

tBBa

tFFatatyyatr ,,

Linear Class of Reaction Functions

Solved using simulation methods

Modeling the Bubble

Time-Varying Transition Probability Model

bubble

bubbleno

bubble

I t

,1

,0

,1

Asset price bubble distributionassuming I(t-1) = 0

0

0.2

0.4

0.6

0.8

-1 0 1

I(t)

Pro

ba

bilit

y

Modeling the Bubble


1,

1,)(

tr

tyttB

B

1),~

(1

1),~

(

0),~

(

0),~

(0

0),~

(

1),~

(1

1),~

(

111,11

111,1

111,0

110,0

111,0

111,11

111,1

,

tttn

ttn

ttn

tt

ttp

tttp

ttp

ttB

sgivenXpyprobabilitwith







A “Macroeconomic Asset Price Bubble”


Sample Path of a Bubble - “Blowing Bubbles”

-20

-15

-10

-5

0

5

10

15

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Time periods

Modeling the BubbleNo-Bubble State Transition Probability

5.0)5.0exp(1

)5.0exp(92.196.0

1

10,0

t

t

y

yP

)exp(1

)exp()1(

1

10,01,0

t

t

y

yPP

1,00,01,0 1 PPP

0

0.5

1

-10 -5 0 5 10

y t-1

Function of yt-1

Modeling the Bubble

Bubble State Transition Probability

)1.04.01.15.2exp(1

)1.04.01.15.2exp(

111

1111,1

ttt

ttt

ry

ryP

)1.04.01.15.2exp(1

)1.04.01.15.2exp(

111

1111,1

ttt

ttt

ry

ryP

0

0.5

1

-5 0 5

y t-1

P1,1

Alternative Policy Specifications

tatyyatr No response to asset prices (simple Taylor rule)

tAPAP

atatyyatr Response to overall asset prices

tBBa

tFFatatyyatr ,,

Differential response to asset price components

Basic Results: Pricking AP Is Optimal

TVTP specification

No asset price response

Constrained response to asset price components

Differential response to

fundamental and non-fundamental

asset prices

ya 1.80 (.03)

1.71 (.04)

1.70 (.06)

a 2.64 (.07)

1.86 (.12)

1.11 (.12)

Fa – .63 (.07)

1.18 (.06)

NFa – .63 (.07)

.10 (.006)

Optimal Policy Parameters

Results for Optimal PolicyV

ari

anc

e o

f in

fla

tio

n

Variance of output

Optimal Monetary Policy Frontiers

tatyyatr **


ari

anc

e o

f in

fla

tio

n

Variance of output


Superior policy


ari

anc

e o

f in

fla

tio

n

Variance of output



Optimal Policy Frontiers

No response to AP



No response to AP

Responseto AP



No response to AP

Responseto 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 ResponsesTwo Types

tj

tststi

tj

sti

e

zzzzX

e

zX

,

,

,

, ),...,()(

dzzfe

zzX

e

X

z tj

tststi

tj

sti )(),...(

]1,0[ ,

,

,

,

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

1

1

1,,,,

1

)1(

)|()|(

i

i

kktjjitjj

itiitt

ppi

jIDFDjIDE

0

5

10

1 21 41

Periods after initial shock

Exp

ecte

d d

ura

tio

n (

per

iod

s)

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


PAYOFF MATRIX

True macroeconomic structure

Asset prices matter

Asset prices do not matter

Asset prices matter

Lmatter, matter=4.2 Lmatter, not matter=4.8 Monetary authority’s view


Lnot matter, matter=5.0 Lnot matter, not matter=4.2


PROBABILITY STRUCTURE

Asset prices matter Asset prices do

not matter

Asset prices matter

Pmatter Pnot matter Monetary authority’s view


Pmatter Pnot matter


Table 5: Optimal monetary policy with paradigm uncertainty

Prior beliefs of the monetary authority that bubbles matter

NET Expected loss

0 -9.2

.1 -7.4

.2 -5.6

.4 -3.8

.5 -1.9

.6 -0.1

.7 1.7

.8 3.5

.9 5.4

1.0 7.2

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

Thank you

How Important Should Bubbles Be In The Conduct of Monetary Policy? By Andrew Filardo, BIS Prepared...

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