Optimal Macroprudential Policy and Asset Price Bubbles

Abstract

An asset bubble relaxes collateral constraints and increases borrowing of credit-constrained agents. At the same time, as the bubble deflates when constraints start binding, it amplifies downturns. We show analytically and quantitatively that the macroprudential policy should optimally respond to building asset price bubbles in a non-linear fashion depending on the underlying indebtedness. If credit is moderate, policy should accommodate the bubble to reduce the incidence of binding collateral constraints. If credit is elevated, policy should lean against the bubble more aggressively to mitigate the pecuniary externalities from a deflating bubble when constraints bind.