Leaning against the wind policy and animal spirits in a general equilibrium model

Abstract

AbstractWe introduce a general equilibrium model with sticky prices and flexible wages. People live over two periods, investing and working in period 1, and consuming in period 2. In the financial market, some investors are informed about the fundamental stock value, while the rest are not, and trust their gut feeling (animal spirits). The informed investors are risk‐averse, and the correlated animal spirits of the uninformed ones affects the stock market equilibrium thus producing an irrational bubble. We find that central bank's leaning against the wind policy is effective in controlling the bubble, if the uninformed investors discount their animal spirits anticipation of future dividends. Moreover, the paper shows that an irrational bubble may have similar effects on stock market prices as a rational bubble.