WORKING PAPER 06-1

Why Central Banks Should Not Burst Bubbles

by Adam S. Posen, Peterson Institute for International Economics

January 2006

Adam S. PosenCentral banks should not burst asset price bubbles. Bubbles generally arise out of some combination of irrational exuberance, jumps forward in technology, and financial deregulation. A central bank is unlikely to persuade investors by raising interest rates that the bubble is ephemeral or that they will not eventually find some greater fool to whom they can sell. More important, the cost of bubbles bursting largely depends upon the structure and fragility of the economy’s financial system. A properly supervised, regulated financial system will not suffer much in real terms from a bubble expanding and bursting. If the financial system is fragile or improperly supervised, then monetary tightening will be even more costly in real economic terms. There is no monetary substitute for financial stability and no market substitute for monetary ease during a severe credit crunch. These two realities imply that the central bank should not take asset prices directly into account in monetary policymaking but should be anything but laissez-faire in responding to sharp movements in inflation and output, even if asset price swings are their source.

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