Asset price bubbles, monetary policy and financial crisis

Abstract

In this paper, asset price bubbles in equities and housing that were developed from August 1987 to September 2008 are examined. Monetary policy reaction functions are estimated. Results revealed that, although not successful in pricking the bubble, the Federal Reserve System did follow a restrictive monetary policy with respect to the equity price bubble. Results also indicate that monetary policy did not respond to housing price bubbles. The findings suggest that the bursting of the housing price bubble in early 2007 resulted in the recent financial crisis. This crisis, together with the rise in oil prices and an unnecessarily restrictive monetary policy, led to the start of the recession in December 2007 and the subsequent collapse of equity prices.