Asset bubbles and inflation as competing monetary phenomena

Abstract

In an economy in which adjusting prices comes at a fixed menu cost, a baseline Taylor rule generates multiple equilibria with varying price rigidity, inflation, and real interest rate. Asset bubbles may be sustained as long as prices are rigid, they burst as inflation picks up and the real rate reverts to a long-term value at which bubbles are no longer sustainable. Unlike natural bubbles, these policy-induced bubbles once issued always crowd out investment by draining resources from the most financially constrained agents.