Question

Which type of bubble poses a larger risk to the financial system/ What are arguments against using monetary policy to burst an asset bubble that is driven solely by irrational exuberance? What are appropriate policy responses to a credit driven bubble?

Answer 1

* Asset bubble poses a larger risk to financial system.

*some economists are of the opinion that use of monetary policy to burst asset bubble should be avoided. Following are the main arguments against using monetary policy to burst asset bubble.

> asset Bubbles are hard to detect. In order to justify leaning against am asset bubble, a central bank must assume that it can identity when asset prices have deviated from fundamental value. The assumption itself is dubious because it is hard to believe that central bank has such as informational advantage over private banks.

> Raising interest rates may be ineffective in restraining the bubble because market participants expect such high rates of return from buying bubble - driven assets.

>There are many asset prices , and at any one time a bubble may be present in only a fraction of assets.Monetary policy actions are a very blunt instrument in such a case, as such actions would be likely to affect prices in general rather than solely those in bubble.

> Bernanke and Gertler in their research found that rising asset prices could would cause a bubble to burst more severely, thus doing even more damage to the economy.

* credit driven bubble arise because information friction create a situation in which entrepreneurs who borrow to produce cross-subsidize those who borrow to buy risky assets. The appropriate policy response to such a bubble will be an effective mix of monetary and fiscal policy

> Tax hikes could be adopted. Economics should figure out how many years of rising prices say ,three or five is needed to create a trend in speculative minds , then policy makers could adopt a rule where capital gain taxes temporarily go up whenever prices rise for that many years to follow. Cutting down the expenditure on areas that won't harm the economy can also be useful.

> central bank will have to tight its monetary policy. Leverage is the ultimate source of instability caused by bubbles. So tampering with borrowing becomes necessary.

> For equity bubbles, marginal requirements will have to be adjusted. Raising the margin requirements will keep the bubble from growing large.

> For property price bubbles, terms of mortgage lending must be changed.Buyer net worth requirements could be rised. Borrowing limits could be imposed either directly, or through risk-based capital requirements on the lenders.

Authorities could turn to regulatory tools to address the issues of credit driven bubble . lt wouldl be better for the economy if interest rate is left to pursue more traditional policy goals.

If the authorities are able to deflate an asset bubble before it busts, it would be huge victory.