how important should bubbles be in the conduct of monetary policy? by andrew filardo, bis prepared...
TRANSCRIPT
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How Important Should Bubbles Be In The Conduct of Monetary Policy?
By Andrew Filardo, BISPrepared for the 10th Dubrovnik Economic Conference
24 June 2004
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Renewed Interest in Research Debate
Don’t React
Bernanke and Gertler (1999) (5-period bubble, realistic policy rules)
React but worry about ability to identify bubbles
Cecchetti, Genberg, Lipsky and Wadhwani (2000) (Wider range of policy rules-still not optimal)
Linearized solution methods raise important questions about the nature of bubbles being studied
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Key Contributions of the Paper
Methodology – simple macro model with a more “satisfying” bubble specification versus more complex macro model
Modeling – endogenous bubbles in a dynamic macro model
Pricking, not just reacting to, bubbles?
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A Fork in the Research Road!
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Preview of Findings
It is optimal to respond to asset prices generally and bubbles specifically!
Volatility of asset prices is not key – it is paradigm uncertainty about the role of asset prices in the macroeconomy that matters
For our purposes, an asset price bubble is an asset price generally considered to be out of line with economic fundamentals = macroeconomic asset price bubbles.
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Monetary Policy and Asset PricesAsset price booms & busts have been extreme
developments that monetary authorities have had to face.
US Nasdaq and S&P 500
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Monetary Policy and Asset Prices
Asset price booms and busts are an important feature of the monetary policy landscape going forward. [Borio, English and Filardo (2003)]
Asset price booms and busts have been extreme developments that monetary authorities have had to face.
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Monetary Policy and Asset Prices
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Recent Policy Maker Statements:
Greenspan, Bubbles and Policy
“[T]he endeavors of policy makers to stabilize our economies require a functioning model of the way our economies work. Increasingly, it appears that this model needs to embody movements in equity premiums and the development of bubbles if it is to explain history.”
Jackson Hole 2002
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A European Perspective
“The problem of how to design monetary policy … [to deal with asset prices and bubbles] … is probably the biggest challenge for central banks in our time.”
O. IssingWall Street Journal
“Should Central Banks Burst Bubbles?”18 February 2004
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Small-scale Macro Model
ttBttt
tttAPttt
yPC
yryIS
1,11
11,11
)(
)()(
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Asset Price Block
tty
ttFF
11,)(
1,
1,)(
tr
tyttB
B
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Monetary Policy
)1
var()var()var(},,,{ rrryL
Ba
Faaya
Min
subject to the model of the macroeconomy and asset prices:
tBEt
AXtX 1
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Monetary Policy
tBBa
tFFatatyyatr ,,
Linear Class of Reaction Functions
Solved using simulation methods
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Modeling the Bubble
Time-Varying Transition Probability Model
bubble
bubbleno
bubble
I t
,1
,0
,1
Asset price bubble distributionassuming I(t-1) = 0
0
0.2
0.4
0.6
0.8
-1 0 1
I(t)
Pro
ba
bilit
y
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Modeling the Bubble
Time-Varying Transition Probability Model
1,
1,)(
tr
tyttB
B
1),~
(1
1),~
(
0),~
(
0),~
(0
0),~
(
1),~
(1
1),~
(
111,11
111,1
111,0
110,0
111,0
111,11
111,1
,
tttn
ttn
ttn
tt
ttp
tttp
ttp
ttB
sgivenXpyprobabilitwith
sgivenXpyprobabilitwith
sgivenXpyprobabilitwith
sgivenXpyprobabilitwith
sgivenXpyprobabilitwith
sgivenXpyprobabilitwith
sgivenXpyprobabilitwith
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A “Macroeconomic Asset Price Bubble”
Time-Varying Transition Probability Model
Sample Path of a Bubble - “Blowing Bubbles”
-20
-15
-10
-5
0
5
10
15
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Time periods
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Modeling the BubbleNo-Bubble State Transition Probability
5.0)5.0exp(1
)5.0exp(92.196.0
1
10,0
t
t
y
yP
)exp(1
)exp()1(
1
10,01,0
t
t
y
yPP
1,00,01,0 1 PPP
0
0.5
1
-10 -5 0 5 10
y t-1
Function of yt-1
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Modeling the Bubble
Bubble State Transition Probability
)1.04.01.15.2exp(1
)1.04.01.15.2exp(
111
1111,1
ttt
ttt
ry
ryP
)1.04.01.15.2exp(1
)1.04.01.15.2exp(
111
1111,1
ttt
ttt
ry
ryP
0
0.5
1
-5 0 5
y t-1
P1,1
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Alternative Policy Specifications
tatyyatr No response to asset prices (simple Taylor rule)
tAPAP
atatyyatr Response to overall asset prices
tBBa
tFFatatyyatr ,,
Differential response to asset price components
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Basic Results: Pricking AP Is Optimal
TVTP specification
No asset price response
Constrained response to asset price components
Differential response to
fundamental and non-fundamental
asset prices
ya 1.80 (.03)
1.71 (.04)
1.70 (.06)
a 2.64 (.07)
1.86 (.12)
1.11 (.12)
Fa – .63 (.07)
1.18 (.06)
NFa – .63 (.07)
.10 (.006)
Optimal Policy Parameters
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Results for Optimal PolicyV
ari
anc
e o
f in
fla
tio
n
Variance of output
Optimal Monetary Policy Frontiers
tatyyatr **
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Results for Optimal PolicyV
ari
anc
e o
f in
fla
tio
n
Variance of output
Optimal Monetary Policy Frontiers
Superior policy
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Results for Optimal PolicyV
ari
anc
e o
f in
fla
tio
n
Variance of output
Optimal Monetary Policy Frontiers
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Basic Results: Pricking AP Is Optimal
Optimal Policy Frontiers
No response to AP
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Basic Results: Pricking AP Is Optimal
Optimal Policy Frontiers
No response to AP
Responseto AP
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Basic Results: Pricking AP Is Optimal
Optimal Policy Frontiers
No response to AP
Responseto AP
Response to F and B
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Two Key Results
1. Responding to asset prices is generally welfare enhancing in this class of models
2. Being able to distinguish bubbles from fundamental asset price movements is of second order importance
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Bottom Line for Monetary Policy
It is generally optimal for a monetary authority to respond to asset price movements:
1. tightening during asset price booms
2. easing during the collapse phase.
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Nonlinear Impulse ResponsesTwo Types
tj
tststi
tj
sti
e
zzzzX
e
zX
,
,
,
, ),...,()(
dzzfe
zzX
e
X
z tj
tststi
tj
sti )(),...(
]1,0[ ,
,
,
,
Gallant, Tauchen and Rossi (1993)
Koop, Pesaran and Potter (1996)
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Nonlinear Impulse Responses
Output
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Nonlinear Impulse Responses
Endogenous bubble models admit richer dynamics
Chaotic behavior is possible
Monetary policy helps to stabilize the economy…
Not only by pricking bubbles but also by opportunistically exploiting bubbles
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Pro-active Monetary Policy Strategies
Defensive strategies – preventing and pricking asset price bubbles
Opportunistic strategies – use bubbles to achieve stabilization goals
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Expected Durations
1
1
1,,,,
1
)1(
)|()|(
i
i
kktjjitjj
itiitt
ppi
jIDFDjIDE
0
5
10
1 21 41
Periods after initial shock
Exp
ecte
d d
ura
tio
n (
per
iod
s)
Negative bubble state
Positive bubble state
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Other Modeling Considerations
Fiscal/prudential policies and monetary policy – What does the monetary authority do if fiscal and prudential authorities don’t do enough?
Complications arising from the zero lower bound for nominal interest rates
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Other Modeling Considerations
Financial stability
Increasingly recognized that price stability and financial stability need not be at odds!
Convert into output and inflation costs – augment the loss function.
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Modeling Extensions
Insurance motives – Does it make sense to insure against low probability events?
Inflation targeting frameworks and the optimal policy horizon
Moral hazard – Does monetary policy stabilization implicitly grant a free put option to investors?
Spillovers – Does the aggressive response to one bubble sow the seeds of other bubbles?
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Paradigm Uncertainty
Policy uncertainty – How can we calibrate the policy response given the inherent uncertainty about whether asset price bubbles truly matter?
Compare the expected gains and losses from reacting to asset prices
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Paradigm Uncertainty
PAYOFF MATRIX
True macroeconomic structure
Asset prices matter
Asset prices do not matter
Asset prices matter
Lmatter, matter=4.2 Lmatter, not matter=4.8 Monetary authority’s view
Asset prices do not matter
Lnot matter, matter=5.0 Lnot matter, not matter=4.2
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Paradigm Uncertainty
PROBABILITY STRUCTURE
Asset prices matter Asset prices do
not matter
Asset prices matter
Pmatter Pnot matter Monetary authority’s view
Asset prices do not matter
Pmatter Pnot matter
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Paradigm Uncertainty
Table 5: Optimal monetary policy with paradigm uncertainty
Prior beliefs of the monetary authority that bubbles matter
NET Expected loss
0 -9.2
.1 -7.4
.2 -5.6
.4 -3.8
.5 -1.9
.6 -0.1
.7 1.7
.8 3.5
.9 5.4
1.0 7.2
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Conclusions
The case for focusing on asset price bubbles – it is a strong case.
Monetary authorities should put emphasis on asset price bubbles in the formulation of policy. Moreover, it might be appropriate to prick bubbles…
… if, and these are big ifs,
- macroeconomic bubbles are deemed important
- the role of these asset price movements on the macroeconomy is well understood
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Thank you