Monetary policy and rational asset price bubbles in a New Keynesian framework: a theoretical analysis

In light of the 2008 financial crisis, this thesis studies the unsettled issue about “should monetary policy lean against rational asset price bubbles” in a New Keynesian (NK) framework, aiming to provide theoretical insights for it.

In the first part of the study (Chapter 2), I adopt a modified NK model with “perpetual youth” overlapping generations as in Galí (2021), where a continuum of equilibria with rational bubbles could exist because of dynamic inefficiency problem. With nominal rigidities and monopolistic competition, bounded bubble fluctuations affect the model economy mainly on the demand side. It shows that allowing an active policy response to a growing bubble could be more effective in terms of achieving macroeconomic stability, especially when the initial size of the bubble is bigger than a threshold value. However, the leaning-against-the-bubble (LAB) policy may have the risk of being “overreacting” if otherwise.

In the second part of the study (Chapter 3 and 4), I establish (in two steps) an analytically tractable NK model with endogenous capital accumulations, where rational bubbles may exist in equilibrium because of the extra liquidity they generate for financially constrained firms with a lumpy investment opportunity. Under certain conditions, bounded bubble-driven fluctuations (in output) may emerge via both supply- and demand-side mechanisms. A LAB strategy may be indispensable under a strict inflation target, but may risk causing an economic downturn in a more pragmatic setting in the face of a bubble-led boom.

Overall, the analyses of the thesis in different scenarios do not strongly favour a LAB policy and emphasise in particular a special overreaction risk that it may suffer relative to its conventional counterpart.