J. Bonchi – Asset Price Bubbles and Monetary Policy: Revisiting the Nexus at the Zero Lower Bound
Asset price bubbles are a major source of macroeconomic instability, but can they play a different role in a low interest rates environment? To answer this question, I study an economy in which the natural rate of interest declines permanently, and the zero lower bound makes risk-free interest rates persistently low. Asset price bubbles redistribute wealth across generations because of the life-cycle pattern of net worth. In this way, they increase the natural interest rate by serving as a store of value for older cohorts and as a collateral for the younger ones, and the central bank can escape from the ZLB with potential output and welfare gains. Output gains are further amplified in presence of capital accumulation and the “financial accelerator”. However, not all bubble types increase the natural interest rate to the same degree and, in this respect, leveraged bubbles have a greater impact than unleveraged bubbles.