Asset Price Bubbles and Monetary Policy: Revisiting the Nexus at the Zero Lower Bound

Abstract

Asset price bubbles are a major source of macroeconomic instability, but can they play a stabilizing role in a low interest rates environment? To answer this question, I study an economy in which the natural rate of interest declines permanently and a long-lasting zero lower bound (ZLB) episode makes risk-free interest rates persistently low. Asset price bubbles redistribute wealth across generations because of the life-cycle pattern of net worth. In this way, they increase the natural interest rate by serving as a store of value for older cohorts and as a collateral for the younger ones, and the central bank can escape from the ZLB with consequent output gains. Therefore, the redistribution of wealth/consumption across generations, which would be welfare-reducing in normal times, becomes welfare-enhancing. However, asset price bubbles affect mainly the natural interest rate through their role of collateral, and a leveraged bubble is the most detrimental for output when it crashes (Jorda et al., 2015).