Question

6. What is an asset price bubble? Should central banks burst asset price bubbles or wait until they burst and mop-up afterwards? Is there an alternative to using conventional monetary policy? [50 marks]

Answer 1

Asset price bubble ?

Asset price bubble is a sustained rise in the prices of financial assets such as housing and equities which takes their values well above long run sustainable levels. Prices can be driven because expectations of future price increases bring new buyers into the market. Aspects of behavioral economics help to explain asset price bubbles.

Should central banks burst asset price bubbles or wait until they burst and mop-up afterwards?

But it is still correct. Two specious arguments against are: “How do you recognize a bubble?” And “How do you fix a target?” There may be no mechanical method of doing either. We may just have to rely on fallible human judgement, as in so many other walks of life. Too many economists are in thrall to the dictum of a Dutch econometrician of seventy years ago who pronounced that you need as many weapons as objectives. By all means, try to develop a new weapon from bank capital ratios—in which I have little confidence. At the end of the day, normal monetary policy may have to be used too. This may mean a compromise between consumer price objectives and asset prices. So what? A more important objection is that borrowers may go abroad to circumvent national borrowing restraints. But I do not believe that an agreed approach by G7 countries will be totally circumvented.

Is there an alternative to using conventional monetary policy?

Conventional monetary policy is at its maximum potential to drive growth under ZIRP. ... However, some economists—such as market monetarists—believe that unconventional monetary policy such as quantitative easing can be effective at the zero lower bound.